By S. Andrew Smith, CPA, Principal, Baker Newman Noyes
This article is the first in a 3-part series on the mechanics and tax benefits of Like Kind Exchanges
Internal Revenue Code Section 1031’s “like-kind exchange” rules allow taxpayers to defer the taxable gain on the sale of real business or investment property if they reinvest in similar business or investment property within a specified time frame. Many transactions qualify, ranging from simple swaps to complicated delayed exchanges. Regardless of complexity level or size, all exchanges that qualify under §1031 have the same effect: the deferral of taxable gain or loss and deferral of related taxes.
Like-kind exchanges have been part of the tax code relatively unchanged for a long time, originally created to allow farmers to swap fields with other farmers without immediately incurring tax. However, the Tax Cuts and Jobs Act (TCJA) of 2017 narrowed the scope of property eligible for like-kind exchanges to include only real property. This significant change has complicated transactions that involve both real property and personal property – such as the sales of apartment buildings or hotels. In June of 2020, the Treasury Department issued proposed regulations that defined “real property” for purposes of IRC §1031 transactions. Prior to the issuance of these regulations, there was uncertainty of whether local law definitions or other rules might apply. In general, real property is now defined as land and all improvements to land, such as buildings and other “inherently permanent structures, and their structural components.”
In addition to defining real property, the proposed regulations also gave taxpayers and their advisors a framework to address transactions involving a combination of real property and personal property. As long as the personal property included in the transaction is incidental to the real property, the transaction may still qualify as a like-kind exchange. In order to meet the definition of incidental, the personal property must be of a type typically transferred with real property in standard commercial transactions, and the aggregate fair market value of the incidental personal property cannot exceed 15% of the aggregate fair market value of the replacement property. In this case, the portion of gain related to personal property may not qualify for tax deferral, but its existence will not taint the overall transaction, and the real property remains eligible. We’ll dive into that more with an example in the second article.
What may be more problematic is the possibility that IRC §1031 will be stricken from the tax code completely or limited further under President Biden’s tax plan. Many speculate that deferred gain may be capped as low as $500,000! That coupled with a proposed increase in capital gains rates has led to a flurry of activity in the commercial real estate market, with taxpayers looking to either cash out or diversify using §1031 prior to a potential law change. Though President Biden’s tax proposal increases the capital gains rate retroactively as of April 28, 2021, the §1031 rules wouldn’t change until December 31. That could lead to a greater incentive to utilize §1031 during the second half of 2021. However, everything is just speculative at this point – these proposals are just that: proposals.
The simplest form of §1031 transaction is the simultaneous exchange: Taxpayer A swaps asset A with Taxpayer B in exchange for asset B. Assuming the market values of assets A and B are equal, the transaction should be tax free for each party. If a party receives additional consideration as part of the proceeds (money or property that is not of a like kind), any gain resulting from that transaction will be taxable, up to the amount of that consideration. That non-qualifying property is described in tax rules as “boot,” and examples of it are cash, non like-kind property and even alleviation of debt. The presence of boot does not necessarily taint the entire transaction; if gain exceeds the amount of boot received, the incremental gain will qualify for deferral.
Simultaneous exchanges can occur without the presence of 3rd party involvement and may even happen without the taxpayers realizing they completed a like-kind exchange, such as trade of business properties. However, most taxpayers planning to sell an asset are unlikely to find another willing party that has a like-kind asset they wish to exchange, and for this reason, the simplest §1031 exchange is somewhat rare. To defer tax under §1031, they need to engage a qualified intermediary (QI) to facilitate a delayed exchange.
We will dive into the more common and more complex delayed exchanges in the next issue!