A like-kind exchange is any exchange of real property held for investment or for productive use in your trade or business (relinquished property) for like-kind investment, trade or business real property (replacement property).
For these purposes, like-kind is broadly defined, and most real property is considered to be like-kind with other real property. However, neither the relinquished property nor the replacement property can be real property held primarily for sale (such as inventory).
In the distant past, most like-kind exchanges were completed at closing. Which is to say that all the parties to the exchange came to the closing, executed their documents and the exchange was completed on the date of closing. Some time later, deferred exchanges became permitted and Congress enacted legislation allowing them. This allowed sellers to convey their relinquished property on a certain date and take title to their replacement property on a later date, within certain limits. At closing, sellers do not receive their cash. The proceeds go to a qualified intermediary. When they acquire replacement property, funds from the deferred exchange are spent until they are fully used or the exchange period expires.
Basic rules of deferred exchanges
45 day rule – property to be acquired has to be identified within 45 days of the closing. Identification is made by listing the property by its name and/or address.
180 day rule – acquisition of replacement property has to be completed within 180 days of closing. This is strictly interpreted. If your 180 days would fall on a weekend or holiday, you don’t get to extend the period to the next business day. In that case, you would have less than 180 days.
3 property rule – up to three properties can be listed in the exchange agreement. This can be exceeded if the rules below are complied with.
200% rule – list of properties in the agreement cannot exceed 200% of the value of the relinquished property. This can be exceeded as long as the 95% rule below is complied with.
95% rule – if the seller closes on 95% or more of the properties on the list in the agreement, then the 200% rule doesn’t apply. An example of this might be if you were selling your 2,000,000 property and you had cash from other sources and wanted to acquire a property worth 6,000,000.
Under the Tax Cuts and Jobs Act, tax-deferred Section 1031 treatment is no longer allowed for exchanges of personal property — such as equipment and certain personal property building components — that are completed after December 31, 2017.
Examples of like-kind property
- Raw land
- Multi-family rental property
- Single-family rental property
- Retail shopping centers
- Office buildings
- Industrial buildings
- Self-constructed property
Examples of property that is not like-kind property
- Partnership interests
- Real estate investment trusts
- Inventory (such as developed lots)
- Personal property (other than real estate: cars, trucks, ships, etc.)
Assuming the proposed exchange qualifies, here’s how the tax rules work. If it’s a straight asset-for-asset exchange, you won’t have to recognize any gain from the exchange. You’ll take the same “basis” (your cost for tax purposes) in the replacement property that you had in the relinquished property. Even if you don’t have to recognize any gain on the exchange, you still must report it on Form 8824, “Like-Kind Exchanges.”
Frequently, however, the properties aren’t equal in value, so some cash or other property is tossed into the deal. This cash or other property is known as “boot.” If boot is involved, you’ll have to recognize your gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you get in the like-kind replacement property you receive is equal to the basis you had in the relinquished property you gave up reduced by the amount of boot you received but increased by the amount of any gain recognized.
An example to illustrate
Let’s say you exchange land (business property) with a basis of $100,000 for a building (business property) valued at $120,000 plus $15,000 in cash. Your realized gain on the exchange is $35,000: You received $135,000 in value for an asset with a basis of $100,000. However, since it’s a like-kind exchange, you only have to recognize $15,000 of your gain. That’s the amount of cash (boot) you received. Your basis in your new building (the replacement property) will be $100,000: your original basis in the relinquished property you gave up ($100,000) plus the $15,000 gain recognized, minus the $15,000 boot received.
Note that no matter how much boot is received, you’ll never recognize more than your actual (“realized”) gain on the exchange.
If the property you’re exchanging is subject to debt from which you’re being relieved, the amount of the debt is treated as boot. The theory is that if someone takes over your debt, it’s equivalent to the person giving you cash and you paying off your debt. Of course, if the replacement property is also subject to debt, then you’re only treated as receiving boot to the extent of your “net debt relief” (the amount by which the debt you become free of exceeds the debt you pick up). For example, if you sell a property that is subject to a 5,000,000 debt and acquire a property with a 10,000,000 debt, only the first 5,000,000 of the debt taken on will reduce your boot.
Like-kind exchanges can be a powerful way to postpone tax liabilities when real estate is sold. Unless there is some major change in the law, with planning, gains can be postponed practically indefinitely. If you are considering a sale of real estate and want to take advantage of Section 1031, it is advisable to begin evaluating replacement property now.
- Relinquished property – property you are giving up in an exchange
- Replacement property – property you are acquiring in an exchange
- Qualified intermediary – party who executes the exchange
- Exchange agreement – document that sets out the terms of the exchange and documents that it meets the requirements
- Boot – cash, debt relief and other property that is not like-kind property
© 2022, all rights reserved.