Do you own a piece of real estate whose fair market value is greater than its basis? Are you contemplating selling and buying another? A 1031 Exchange may be for you!
In a Section 1031 Exchange, also known as a “like-kind” exchange or a Starker exchange, the taxpayer does not recognize and pay tax on the gain on an exchange of like-kind properties so long as both properties are held for use in a trade, business, or investment purposes.
There are specific guidelines to follow to qualify for a Section 1031 exchange. The first is the term “like-kind.” Luckily, like-kind is a broad term. For example, a rental property can be exchanged for raw land, and vice-versa. A multi-family rental property can be exchanged for commercial property, a warehouse for an office building, residential apartment building for a storefront, etc. According to the IRS, so long as the properties being exchanged are of the same nature, character, or class, they would qualify (e.g., Real Property for Real Property, etc.). Second, this provision applies to business or investment property only. You cannot exchange your primary residence for another home. For example, if you are moving from Rhode Island to another state, the sale of your home and purchase of a new home would not qualify for like-kind treatment.
Third, the IRS requires that the value of the property and equity purchased must be the same as or greater than the property given up in exchange. To qualify for 100% deferral of the gain, an example would be a piece of property worth $500,000 with a $100,000 mortgage attached. It would have to be exchanged for another piece of property with a minimum value of $500,000 and a $100,000 mortgage retained. This leads us to another rule: A taxpayer must not receive “boot” in the transaction to qualify for 100% deferral of the gain. Any boot received is considered taxable to the extent there is realized gain on the transaction. For example, you own a property worth $1,500,000, and you are exchanging it for a qualified property worth $900,000. The $600,000 cash received in this instance would be considered “boot,” and you would pay tax on the amount up to the gain on the property.
Because simultaneously swapping properties is rare between two owners, you’ll engage in a “deferred” exchange where you enlist the help of a QI (qualified intermediary). Additionally, there are a few time constraints when conducting like-kind exchanges. You, as the property owner, have up to 45 days after selling and closing on your original property to identify up to three potential pieces of like-kind exchange property. The replacement property needs to be received and the exchange completed within 180 days from the sale of your original property or the due date of your income tax return (including extensions) for the tax year in which the relinquished property was sold – whichever is earlier. Please note that there are no extensions available for the 45-day and 180-day periods.
To add more to the like-kind exchange gamut, the recently enacted Tax Cuts and Jobs Act (TCJA) changed a rule related to like-kind exchanges. For exchanges completed after December 31, 2017, the TCJA limits these like-kind exchanges to real property not held primarily for sale (real-property limitation.) Therefore, after December 31, 2017, personal property and intangible property no longer qualify. There are transition rules that only apply in certain circumstances.
All these rules and guidelines can confuse even the most astute investors. Many areas in the like-kind exchange arena can trip you up and therefore disqualify transactions from tax deferral. If you are contemplating a like-kind exchange, please give us a call at (401) 921-2000 and we would be more than happy to assist you.