Deferring Taxes via Like-Kind Exchanges

Thomas R. Tartaglia, CPA (May, 2015)

A like-kind exchange can very simply be defined under the United States tax law as, “A transaction or series of transactions that allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the sale of the first asset.” Like-kind exchanges are also referred to as “1031 exchanges,” which is the specific code section of the Internal Revenue Service that defines the exchange.

The transaction itself and all the rules and regulations associated with it are not as simple as the definition would indicate. You have to consider the types of property being exchanged, you must transact the exchange within specific time frames, you will need an “intermediary” to handle the “cash” and there are restrictions as to who you can exchange with. Also, the 1031 exchange is for business or investment assets only; it is not for personal use.

As indicated earlier, the “gain” portion of the exchange is only deferred to a later date as the gain will carry over to the “new” asset and will eventually be realized when the replacement asset is sold. The IRS states, “It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations.” Current rules require taxpayers to submit Form 8824 (attached to your tax return) to the IRS detailing the terms of the deal.

One of the critical issues is determining whether the assets are of a “like-kind”.  The tax code does not define what constitutes like-kind property, but Treasury Regulation 1.1031(a)-1(b) defines it by referring to it as property of the same nature or character and not by its quality or grade. For example, it does not matter that any real estate involved is improved or unimproved as they would be of the same nature or character. Note one exception is that property within the United States cannot be exchanged for property in a foreign country. Also if “unlike” property (referred to as boot) is included in the exchange, a partial gain will be currently taxable. Boot is considered any unlike property, cash or assumption of debt encumbering the like-kind property. Several types of assets will never qualify as like-kind property regardless of how similar they may be. IRC section 1031(a) lists the following assets that do not qualify:

  • Inventories
  • Stocks (except stock-for-stock in the same corporation)
  • Bonds
  • Notes
  • Other types of securities
  • Partnership interests
  • Certificates of trust

Like-kind exchanges must be completed within a specific time frame. The simplest type of Section 1031 exchange is a simultaneous swap of one property for another. Another type is a delayed (three party) transaction also referred to as a “Starker Exchange”. In a delayed exchange proceeds from the sale must be used to purchase the new property within 180 days of the sale of old property or the due date of the tax return (including extensions) for the tax year in which the relinquished property was sold, whichever is earlier. The other time restriction is that the new property must be identified within 45 days of the sale. The identification must be in writing, signed by you and delivered to a person involved in the exchange.  Also, replacement properties must be clearly described in the written identification. Accordingly in the case of real estate, a legal description, street address or distinguishable name must be included. Once the sale occurs, the cash must go directly to a third party intermediary (normally an attorney or a broker, but not someone who has worked for you) who will complete the purchase of the “replacement property”. If any of these steps are excluded or time limits exceeded, even by one day, the transaction will become fully taxable.

Who qualifies for the Section 1031 exchange? Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships, limited liability companies, trusts and any other taxpaying entities may set up an exchange of business or investment properties under Section 1031. Exchanges between family members will not qualify for deferred tax treatment.

As you can see, unlike the simple definition, the like-kind exchange transaction can be very complex. If you are considering entering into one of these tax deferred arrangements, please consult one of the tax professionals here at Dermody, Burke and Brown, CPAs, LLC. 

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