Section 1031 (like-kind exchanges) offer the opportunity to exchange one income or business property for another, and defer (not currently pay tax on) the gain in until the new property is later disposed in a taxable transaction. There is no limit to the number of times a taxpayer can take advantage of Section 1031 exchanges. Brokers and parties to transactions use Section 1031 exchanges when a party would not be willing to sell in a taxable transaction, or when buyers are cash poor but have other business or investment property, or will have no capital gains tax currently due because of Section 1031.
THE IRS CODE…
Section 1031 says that when property is “exchanged” for another property that is “like kind,” some or all of the gain which is “realized” (received) may not be “recognized” (taxed currently). For example, if a taxpayer exchanges one income or business property which has an adjusted basis of $50,000 and a value of $100,000, for another qualified like-kind property valued at $100,000, a gain of $50,000 is “realized,” but it would not be currently recognized as taxable, due to the provisions of Section 1031.
Note that Section 1031 cannot be used for property that is personal use property, such as a principal residence. A single-family residence that is used as a rental property does qualify, however. Section 1031 says that no gain or loss is currently recognized if the business or investment property is exchanged for other like property which will be held for use in a trade or business, as an investment, or for production of income.
If an exchange is made for property that is both like-kind and not like-kind, such an apartment building being exchanged for a fleet of trucks and an office building, then some of the gain will be recognized (taxable) by the Internal Revenue Service (IRS). (The trucks are personal property, unlike the apartment building and the office building which are both real property. In general, all real property will be considered like-kind with all other real property, as long as both parcels are U.S. real property held for use in a trade or business, as an investment, or for production of income. This non-recognition by the IRS is not necessarily permanent. More correctly, the gain is postponed or deferred until a later taxable transaction.
The exchange has specific time frames that need to be completed. After disposing of the downleg property, the tax payer must: “Identify” the upleg property within 45 calendar days of the transfer of the downleg property. Acquire (close escrow on) the upleg property no later than the earlier of:
(a) 180 calendar days after the downleg property is transferred, or
(b) the due date (determined with regard to extension) of the tax return for the year in which the downleg was transferred away.
The fair market value of the upleg property must be equal to or greater than the fair market value of the downleg property to avoid paying tax on any gain. In addition, a taxpayer must receive equity in the upleg property equal to or greater than the equity given up on the down leg property to avoid any taxable “boot.”
Therefore, in an exchange, it is the equities of the two properties that are exchanged. The equity is the property market value minus any mortgages, liens or any other encumbrances. Finding two properties with equal equity is rare. It is possible for one party with greater equity to, for example, take on an additional mortgage in order to make the equities equal. Also, along with the exchange of the properties, one party can give the other notes, cash, a car or other personal property to balance out the equities.
KEY TERMS –
Accomodator – the entity that will act at the middleman for the exchange. In general, the accommodator helps with the transfer of title and holds the proceeds. The accommodator should be a party to the escrow, and possibly to the acquisition agreement, too. The taxpayer should enter into an “exchange agreement” (i.e., contract) with the accommodator specifying what the taxpayer requires the accommodator to accomplish and the timing of the accommodator’s actions.
Downleg – the original property being exchanged.
Upleg – the new property being exchange into.
Boot – Cash or other property that doesn’t qualify for the 1031 exchange but is added to the exchange to make the numbers work. It is taxable.
