Like Kind Exchanges

Assume you hold income-producing real property that has gone up in value. You want to sell the property, but don’t want to sacrifice a significant portion of your profit to capital gains tax. Instead, you want to utilize the gain from the sale to increase your net worth, or net rental income, by trading up into a larger investment property. Is there anything you can do?  Thankfully, the answer is yes.

Section 1031 of the Internal Revenue Code allows taxpayers to sell certain real and personal property while deferring tax liability by exchanging the current property (relinquished property) for qualified use “like-kind” property (replacement property). To put it another way, a taxpayer who wants to sell an old piece of property and use the proceeds to buy a new property will be able to defer taxes otherwise payable on the sale of the old property as long as the new property is purchased to replace the existing property. The process is called a 1031 exchange or a “like-kind” exchange, sometimes also referred to as a “Starker exchange.”

For example, assume Joe bought a strip mall for $300,000 in a soft market, and sells it today for $500,000. Joe must pay capital gains on the profit of $200,000. However, if Joe takes the proceeds of the sale and buys another strip mall worth $500,000 or more, he has completed a like-kind exchange and has deferred the capital gains tax until he profits from the new investment. Joe, therefore, gets the immediate benefit of his entire profit which allows him to “trade up” to a better property.

Joe doesn’t have to invest all of the proceeds from the sale in the replacement property. However, the portion not invested will be subject to capital gains tax.

Although the basic concept is quite simple, as with most things in life the devil is in the details. There are a host of requirements that must be met in order to take advantage of the tax deferment.

First, not all property can be subject to a like-kind exchange. For example, as a general rule your primary residence doesn’t count. Instead, only property held for productive use in trade or business or property held for investment benefits from a like kind exchange. This is called “qualifying use” property.  Property not held for rental, investment or business use will not qualify. For example, property acquired with the intent to fix up and sell (“flipping”) is qualified as property held for sale and hence does not satisfy the qualifying use test.

Second, assuming you have qualified use property, you must also satisfy the “like-kind” test. Real property is “like-kind” to any other real property. For example, a multi-unit rental property need not be exchanged only for another multi-unit rental property – it can be exchanged for an office building. Property eligible for 1031 exchange treatment includes raw land, commercial office buildings, shopping centers, farmland, oil and gas interests, leases of more than 30 years, rental houses, factories and the like.  Vacation property and second homes also qualify, but only if they are held as investment property for at least 24 months, are rented for at least 14 days each year within those 24 months, and are not used personally for more than 14 days or ten percent of the number of days that you rented the property.

The rules are a bit more restrictive for personal property. Aircraft, automobiles, trucks, office equipment, furniture, machinery, billboards, franchise licenses, and copyrights are just a few permissible examples. Inventory, stocks, bonds, notes and other securities, however, are excluded from the scope of 1031 exchanges.

The IRS imposes stringent timelines for this process. Replacement property must be identified within 45 days of the initial sale. Multiple properties can be identified, but special rules apply that are beyond the scope of this article. Accordingly, the savvy investor should already have his or her replacement property in mind before offering the relinquished property for sale. Finally, acquisition of the replacement property must be completed within 180 days of the initial sale. These deadlines are inflexible, and if they are violated the benefits of this exemption evaporate. Keep in mind that the time limits are calculated to include weekends and holidays. 

It’s also possible to acquire the replacement property before selling the relinquished property. This is called a “reverse exchange.” Slightly different rules apply, but the benefits are the same.  Reverse exchanges are generally more complex and cost more in fees.

If the taxpayer personally receives the proceeds from the sale of the relinquished property the IRS will not defer the capital gains tax. Rather, the proceeds must be received by a “qualified intermediary.” The qualified intermediary must be an independent entity who is not the taxpayer or a related party. The taxpayer enters into an “exchange agreement” with the qualified intermediary. That exchange agreement limits the taxpayer’s access to the proceeds and also directs the qualified intermediary to acquire the relinquished property from the taxpayer, to transfer it to the buyer, to acquire the replacement property, and then to transfer the replacement property to the taxpayer.

The qualified intermediary must be assigned the agreements for the sale of the relinquished property and the acquisition of the replacement property. In other words, the transactions are accomplished in the name of the qualified intermediary for, in essence, your benefit. This requirement is strictly enforced and failure to satisfy it will result in recognition of the capital gain income tax liability.

Most title companies have affiliates that do nothing but 1031 exchanges. For a fee they provide turn-key service.  Fees depend on the size of the transaction. However, if the amount of gain you seek to protect is small, it may not make economic sense to engage in a 1031 exchange.  Reputable providers of these services are bonded and hold proceeds in an interest-bearing bank trust account. 

A like-kind exchange is an excellent way to avoid capital gains taxes on a transaction if your ultimate goal is to reinvest the funds anyway. However, because of the many rules, it’s best to contact your tax or legal counsel before heading down this road.