Are you thinking about divesting a real estate investment and then replacing it with another property? If you sell appreciated property outright, you’ll incur a taxable gain, which lowers the amount available to spend on the replacement property. But you may be able to defer your tax bill (or even make it disappear) with a Section 1031 like-kind exchange.
Unfortunately, there are rumors that upcoming tax reform legislation could eliminate the time-honored like-kind exchange privilege. So, while tax breaks for like-kind exchanges are still in place, it could be a good idea to complete any like-kind exchanges that you’re considering sooner rather than later. Here’s what you need to know about like-kind exchanges under the current tax rules.
Beware of the Boot
To avoid any current taxable gain in a like-kind exchange, you must not receive any “boot” in the transaction. Boot means cash or other property that isn’t of a like kind to the relinquished property. When mortgaged properties are involved, boot also includes the excess of the mortgage on the relinquished property (the debt you get rid of) over the mortgage on the replacement property (the debt you assume).
If you receive any boot, you’re taxed in the year the property is sold on a gain equal to the lesser of:
1. The value of the boot, or
2. Your overall gain on the transaction based on fair market values.
So, if you receive only a small amount of boot, your exchange will still be mostly tax-free (as opposed to completely tax-free). On the other hand, if you receive a significant amount of boot, you could have a large taxable gain.
The easiest way to avoid receiving any boot is to swap a less valuable property for a more valuable property. That way, you’ll be paying boot, rather than receiving it. Paying boot doesn’t trigger a taxable gain for you.
What Constitutes Like-Kind Property?
You can arrange for tax-free real property exchanges as long as the relinquished property (the property you give up in the exchange) and the replacement property (the property you receive in the exchange) are of a like kind. Under Internal Revenue Code Section 1031 and related guidance, “like-kind property” is liberally defined. For example, you can swap improved real estate for raw land, a strip center for an apartment building or a boat marina for a golf course.
But you can’t swap real property for personal property without triggering taxable gain, because real property and personal property aren’t considered like-kind. So, you can’t swap an apartment building for a cargo ship. You also can’t swap property held for personal use, such as your home or boat. Inventory, partnership interests and investment securities are also ineligible for like-kind exchanges. As a result, the vast majority of tax-free like-kind exchanges involve real property.
In 2002, the IRS clarified that even undivided fractional ownership interests in real estate (such as tenant-in-common ownership interests) can potentially qualify for like-kind exchanges. For example, if you sell an entire commercial building, you don’t need to receive an entire commercial building as the replacement property in order to complete your tax-free exchange. Instead, you could receive an undivided fractional ownership interest in a building as the replacement property.
What Happens to the Gain in a Like-Kind Exchange?
Any untaxed gain in a like-kind exchange is rolled over into the replacement property, where it remains untaxed until you sell the replacement property in a taxable transaction.
However, under the current federal income tax rules, if you still own the replacement property when you die, the tax basis of the property is stepped up to its fair market value as of the date of death — or as of six months later if your executor makes that choice. This beneficial provision basically washes away the taxable gain on the replacement property. So your heirs can then sell the property without sharing the proceeds with Uncle Sam.
The like-kind exchange privilege and the basis step-up-on-death rule are two big reasons why fortunes have been made in real estate.
However, as noted earlier, the like-kind exchange privilege could possibly be eliminated as part of tax reform. Even if that doesn’t happen, the estate tax might be repealed, which could also ultimately reduce the tax-saving power of like-kind exchanges.
Why? An elimination of the step-up in basis at death might accompany an estate tax repeal. For example, with the 2010 federal estate tax repeal (which ended up being temporary and, essentially, optional), the step-up in basis was eliminated, and that could happen again. An elimination of the step-up in basis would mean that a taxpayer inheriting property acquired in a like-kind exchange would have the same basis in the property as the deceased, and thus could owe substantial capital gains tax when he or she ultimately sells the property.
What’s a Deferred Like-Kind Exchange?
It’s usually difficult (if not impossible) for someone who wants to make a like-kind exchange to locate another party who owns suitable replacement property and also wants to make a like-kind exchange rather than a cash sale. The saving grace is that properly executed deferred exchanges can also qualify for Section 1031 like-kind exchange treatment.
Under the deferred exchange rules, you need not make a direct and immediate swap of one property for another. Instead, the typical deferred like-kind exchange follows this four-step process:
1. You transfer the relinquished property (the property you want to swap) to a qualified exchange intermediary. The intermediary’s role is to facilitate a like-kind exchange for a fee, which is usually a percentage of the fair market value of the property exchanged.
2. The intermediary arranges for a cash sale of your relinquished property. The intermediary then holds the resulting cash sales proceeds on your behalf.
3. The intermediary uses the cash to buy suitable replacement property that you’ve identified and approved in advance.
4. The intermediary transfers the replacement property to you.
This series of transactions counts as a tax-free like-kind exchange, because you wind up with like-kind replacement property without ever taking possession of the cash that was transferred in the underlying transactions.
What Are the Timing Requirements for Deferred Like-Kind Exchanges?
For a deferred like-kind exchange to qualify for tax-free treatment, the following two requirements must be met:
1. You must unambiguously identify the replacement property before the end of a 45-day identification period. The period starts when you transfer the relinquished property. You can satisfy the identification requirement by specifying the replacement property in a written and signed document given to the intermediary. That document can list up to three properties that you would accept as suitable replacement property.
2. You must receive the replacement property before the end of the exchange period, which can last no more than 180 days. Like the identification period, the exchange period also starts when you transfer the relinquished property.
The exchange period ends on the earlier of: 1) 180 days after the transfer, or 2) the due date (including extensions) of your federal income tax return for the year that includes the transfer date. When your tax return due date would reduce the exchange period to less than 180 days, you can extend your return. An extension restores the full 180-day period.
Will Like-Kind Exchanges Survive Possible Tax Reform Efforts?
Under the current tax rules, like-kind exchanges offer significant tax advantages, but they can be complicated to execute. Your tax advisor can help you navigate the rules.
Looking ahead, it’s uncertain when and if tax reform will occur and whether the tax benefits of a like-kind exchange will survive any successful tax reform efforts. So, if you own an appreciated real estate investment and you’re contemplating swapping it out, it may be advisable to enter into a like-kind exchange sooner rather than later.