The Internal Revenue Code (IRC) contains the rules for when and how the federal government may tax property. In certain circumstances, taxpayers are able to temporarily avoid paying taxes on real estate transactions. Section 1031 of the code, is the “like-kind exchange” provision. This provision may allow for a taxpayer to temporarily avoid paying taxes.
A like-kind exchange is the exchange of real property used for business or investment purposes, solely for other business or property. The original property and the property for which it is exchanged must be of the same type; that is, “like-kind.” This means that both properties in the exchange must be for business or investment purposes.
In a deferred like-kind exchange, when an individual exchanges the property at a gain or profit, taxation of that profit is deferred or postponed. For an exchange to qualify as a deferred like-kind exchange, an individual can postpone paying tax, provided the profits are invested into the “new” property. The profit is eventually taxed, as capital gains. The taxation occurs when the new property is sold.
Deferred like-kind exchanges are subject to time limits. For an exchange to qualify as a deferred like-kind exchange, the owner of the property being exchanged must find a like-kind property within 45 days of the sale of the original property. To prevent people from taking advantage of the system, the owner of the original property must complete the exchange within 180 days of sale of the original property.
What Does “Identify” Mean?
For an exchange to qualify as a deferred like-kind exchange, the “new” property must be identified within 45 days of the sale of the original property. The new property is identified when the taxpayer identifies which specific replacement property they intend to acquire in the exchange. The identified property need not be under contract within the 45 days. However, once a like-kind property is identified as part of the exchange, that property and only that property may be used in the exchange.
The identification itself must be in writing. The taxpayer must sign the writing. The property must be described in sufficient detail to unambiguously identify it. This means the property must be described with enough detail that it cannot be mistaken for other property. An individual may identify property using its address, or lts legal description.
If the property has a number, such as a unit number, the unit number should be in writing. st be in writing and signed by the taxpayer, and the property must be unambiguously described. This generally means that the taxpayer identifies either the address of the property or its legal description.
A deferred like-kind exchange can be finalized within 180 days after it is made. For example, if someone sells a parcel of land, the person has 45 days to identify a like-kind property. However, the individual has 180 days from the date of sale of the original property to complete the purchase of the new property. The IRS may grant an extension of time to allow for the like-kind exchange to be completed within a given tax year.
What Qualifies as a Deferred Like-Kind Exchange?
Section 1031 spells out what constitutes the “like-kind” property for an exchange to qualify as a like-kind one. Before 2017, a like-kind exchange could involve exchanging real property for other real property. It could also have involved exchanging personal property for personal property. In 2017, the passage of the Tax Cuts and Jobs Act changed the law. Now, only real property that is held for business, trade, or investment, qualifies for a deferred like-kind exchange.
Not all real property qualifies. Real property that does not qualify includes:
- Primary residences;
- Property held outside of the United States; and
Securities, stocks, bonds, and other financial assets do not constitute real property. Therefore, they cannot be used as part of an exchange. Before the changes to tax law in 2017, this property could qualify as like-kind exchange property. It no longer does.
Under IRS regulations, a variety of items constitute property. These include:
- Land and improvements to land. An improvement is an improvement to an “inherently permanent structure.”
- Crops attached to land
- Natural products of land, such as oil.
- Water and air space that are part of land.
- Options to acquire real property.
In addition, for an exchange to qualify as a deferred like-kind exchange, the sale of the properties cannot be direct. This means that the original property must be sold, and afterward, the new property must be purchased, in a separate transaction.
The following are actual examples (among others) of like-kind exchange property:
- Multi-family dwellings;
- Commercial property, such as hotels;
- Land on which nothing has been built; and
- Condominium rentals.
Can Personal Property Ever Qualify as Like-Kind Property?
The law permits incidental or small amounts of personal property to be included in sale of qualifying like-kind property. For this personal property to be included as part of the value of the property, the personal property must be transferred along with the real property.
For example, office furniture included in the sale of a commercial building may qualify. The total value of the personal property may not exceed 15% of the value of the replacement real property.
What Problems May be Involved With a Deferred Like-Kind Exchange?
A like-kind exchange must be completed with the use of a qualified intermediary. This person acts to complete the purchase of the replacement property by the buyer (and sale of that property by the seller). The IRS has strict rules about qualified intermediaries. An individual may not use a qualified intermediary to also serve as an attorney or tax advisor.
Therefore, someone who wants to use an attorney or tax advisor must ensure that the attorney or tax advisor is not the same person as the intermediary. If the intermediary and the attorney or the intermediary and accountant are the same person, the IRS can refuse to recognize the exchange as a deferred like-kind exchange.
In certain circumstances, a taxpayer may not want an exchange to qualify as a deferred like-kind exchange. Instead, the taxpayer may want to recognize a loss in the exchange. A recognized loss may be reported for income tax purposes.The loss may be carried over into future tax periods. A loss is deducted from income. As a result, an individual pays less capital gains tax when taking a loss.
The presence of “boot” may complicate a like-kind exchange. “Boot” is the portion of sales money a seller receives from an exchange that is not re-invested in replacement property. For example, if someone sells property for $300,000, but only reinvests $100, 000, the difference of $200,000 is known as “boot.” Any boot money that a seller receives is taxable. The presence of boot prevents a deferred like-kind exchange from being deferred for the full value of the property sold.
Do I Need an Attorney to Help Me with My Tax Problems?
If you have questions about the tax consequences of a deferred like-kind exchange, you should contact a tax attorney. An experienced tax attorney near you can analyze the circumstances of the exchange, and advise you as to whether and when taxes are owed. The attorney can also represent you in hearings or court proceedings with the IRS.