What is the 1031 Exchange of Like Kind Property
Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.
This is the 1031 Exchnage of like kind proprety, or Tax Deferred Exchange of Property.
Certain exchanges of property are not taxable. This means any gain from the exchange is not recognized, and any loss cannot be deducted. Your gain or loss will not be recognized until you sell or otherwise dispose of the property you receive.
Internal Revenue Code 1031 (commonly known as “like-kind exchange”) is one method a taxpayer may use to defer their tax bill. The 1031 exchange applies to property held for investment only. A personal residence does not qualify for the 1031 exchange.
There are many names for these exchanges, including: 1031 exchange, Starker exchange, tax-free exchange, tax-deferred exchange, trading properties, delayed exchange, like-kind exchange, etc…
The nature of this transaction is a “deferred exchange“. What this means is that you transfer your real estate investment property to another real estate property which you will hold for investment.
1031 Exchange Requirements
To be a 1031 exchange, the property traded and the property received must be of the following:
- 1. Qualifying property – Both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business.
- 2. Like-kind property – These are properties of the same nature and character, even if they differ in quality. The exchange of a rental property for another rental property is an exchange of like-kind property.
If the exchange of like-kind property involves the receipt of money or unlike property or the assumption of your liabilities, you may have to recognize the gain.
1031 Exchange Steps
The 1031 exchange is generally accomplished with little effort on the part of the buyers and sellers. The steps are as follows:
- 1. List your property for sale with your real estate agent.
- 2. When you get an offer, your agent will include a counteroffer provision that states the “buyer agrees to cooperate with seller’s 1031 exchange.
- 3. Open escrow and choose your accommodator or qualified intermediary; these are the facilitators of the exchange process who hold the proceeds from the sale of the relinquished property until the purchase of the replacement property is ready to close. Your real estate agent can help you choose or recommend an qualified accommodator. Be careful who holds your money. And especially be careful in choosing someone over the Internet.
- 4. Sign and exchange agreement with your accommodator through escrow along with other paperwork.
- 5. At the close of escrow, your proceeds will be transferred to your accommodator’s trust fund on your behalf and held there until you begin the process of buying your replacement property.
Equal or Higher Price
To defer all capital gain taxes on the sale of a property through the 1031 like-kind exchange, the replacement property must have a price equal to or higher than the relinquished property. For example, if you had a property that you sold for $180,000, the value of your replacement property must be at least $180,000. You can still make a like-kind exchange if the property is less than $180,000, but you will have to pay taxes on the difference.
The basis of the property received in the like-kind exchange is the same as the basis of the property you transferred. For example, Skip exchanged real estate held for investment with an adjusted basis of $150,000 to another real estate investment. The fair market value of the new property is $315,000. The basis for his new property is the same as the basis of the old, $150,000.
Depreciation you may have taken out on your rental properties also affect the basis of the newly acquired property.
1031 exchange example 1: You originally purchase a rental house for $150,000 and you have accumulated depreciation of $80,000. This means that the basis in your property is $70,000 ($150,000 – $80,000). Let’s assume you sell it and do a like-kind exchange for another rental house that has a fair market value of $250,000. The adjusted basis would transfer and represent the first $150,000 of the replacement property. Thus, the beginning basis on the replacement property after the exchange would be $170,000 ($70,000 base of the relinquished property and the $100,000 additional amount paid to get the $250,000 purchase price).
1031 Like-Kind Exchange Time Limits
You must identify the property to be received within 45 days after the date you transfer the property given up in the exchange. This period is called the “identification period”. Any property received during the identification period is considered to have been identified. Thus is a very strict rule. There are no extensions because of holidays, illness, or anything else.
Your replacement property must be received within 180 days of the closing and transfer of the relinquished property or the due date for the transferor’s tax return for the taxable year in which the transfer of property took place. It is critical that you understand this timing rule, as the example below shows.
1031 exchange example 2: Tony begins to make his 1031 like-kind exchange on December 20, 2013 when the property he was selling closed escrow. By early April 2014 Tony has identified his replacement property and escrow will close at the end of the month. On April 14, Tony files his taxes. It’s clear to see that Tony is well within the 180 day time limit. He will NOT be eligible for the like-kind exchange however. The reason is that he filed his income taxes on time. The rule clearly states that the replacement property must be received within 180 days or the due date of the tax return for the taxable year in which the transfer of property took place. Tony could have filed an extension for his income tax returns and waited to file until after the replacement property had been received.
As with the above time limit, there are no extensions for the 180 day time limit.
1031 Exchange “Boot”
When you use the 1031 exchange, anything your receive which is not like-kind property is considered “boot”. Boot is fully taxable. There are two types of boot that you need to understand:
- 1. Cash boot – Say you exchange a property worth $225,000 with no mortgage for for a property worth $200,000 with no mortgage, you would receive $25,000 in cash. Cash is not “like-kind” to real estate. Thus, the $25,000 is considered boot and is taxable.
- 2. Net debt relief – Say you exchange a property worth $310,000 with a mortgage of $100,000 for another property worth $$290,000 with a mortgage of $80,000, you will receive no cash. But, your debt has been reduced by $20,000. This debt reduction is boot and is taxable.
Alternative and Multiple Replacement Properties
You can identify more than one replacement property. Regardless of the number of properties you give up, the maximum number of replacement properties you can identify is the larger of the following:
- Any number of properties whose total fair market value (FMV) at the end of the identification period is not more than double the total fair market value, on the date of the transfer, of all the properties you give up.
1031 Exchange Losses
If you have a loss on a 1031 exchange, the loss is NOT deductible.
Foreign Real Property Exchanges
Real property located in the United States and real property located outside of the United States are not considered like-kind property under the like-kind exchange rules. If you exchange foreign real property for property located in the United States, your gain or loss on the exchange is recognized by the IRS.
1031 Exchanges Between Related Persons
Relatives are allowed to exchange investment real estate, if they meet the IRS criteria above, and defer taxes in the process. If either party, however, disposes of the property within 2 years after the exchange, the tax free 1031 exchange is disqualified.
The exception to this is if one of the people involved in the exchange of real estate dies.