Episode 431: 1031 Like-Kind Exchanges: Definition and Considerations

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1031 like-kind exchanges are a tax provision dictated by section 1031 of the Internal Revenue Code. They are used to defer taxes on capital gains resulting from a sale of real property, and therefore are an option for taxpayers who want to reinvest their funds into a different property.

Although 1031 exchanges are mostly straightforward, there are rules and deadlines to observe during the process. Failing to observe these rules may result in an expensive tax bill (and penalties). So, before engaging in a 1031 exchange, it is recommended that investors consult with a knowledgeable tax attorney first.

How a 1031 Like-Kind Exchange Works – a Small Business Example

1031 exchanges are generally reserved for investment purposes – a rule cemented by the 2017 Tax Cuts and Jobs Act (TCJA). Prior to the TCJA, tax paying entities could swap out some types of personal property (such as equipment), but 1031 exchanges are now confined to real estate property exchanges only.

For example, a small business owner – let’s say an auto dealership owner – decides that his current location is no longer suitable for his current needs, or perhaps the value of his current property has skyrocketed. Being a savvy investor, he starts looking for another location that might serve his auto dealership better and prepares to sell his current property. After a brief search, he finds an excellent location in a nearby suburb.

Economically, it’s better for everyone – the business owner, the real estate companies, the local community and the IRS – for this transaction to go ahead. It drives additional economic activity and produces additional tax revenue. However, by selling his current property, the auto dealership owner must pay capital gains taxes from the  proceeds of the sale.

To prevent taxes from blocking important economic activity, the IRS allows investors to switch out one like-kind property for another and defer capital gains taxes in the process. This is the tax-led philosophy behind allowing 1031 like-kind exchanges.

In this example, the auto dealership owner opts for a 1031 exchange to essentially move his business to a better location, using the funds generated from the initial property’s sale to acquire the new property. Any capital gains taxes generated from the sale are deferred, perhaps indefinitely.

This is a general overview of 1031 exchanges. In practice, there are several moving parts during the 1031 exchange process that taxpayers must manage to successfully see the process through.

The 1031 Like-Kind Exchange Process

If you and your tax attorney agree that a 1031 exchange makes sense for your current tax needs, here is what the process typically looks like:

• Determine which properties to exchange – First, you’ll need a pair of real properties to exchange. They must be “like-kind,” though the IRS’s definition in this area is broad. As long as both properties are investment properties, a 1031 is acceptable in most cases. Taxpayers can exchange an apartment complex for an industrial center, for example.
• Identify an intermediary (middleman) to facilitate the transaction – 1031 exchanges are automatically invalidated if the taxpayer accesses the proceeds from the sale at any point. Once the initial property is sold, the proceeds must be given to an intermediary that holds the funds in escrow. Those funds are used to facilitate the purchase of a new property. There are dedicated exchange facilitators who can serve in this role for investors.
• Make the exchange – From the date that the initial property is sold, you have 45 days to identify up to three potential exchange properties. These must be identified in writing and given to the intermediary. There’s a second deadline. From the date of sale, you have 180 days to purchase the new property.
• Notify the IRS of the 1031 exchange – Once the 1031 exchange is complete, the buyer must report the transaction to the IRS, using Form 8824. The buyer will need to provide details of the transaction, including the properties, parties and dates involved. They will also need to report the adjusted tax basis of the sold property.

Important 1031 Like-Kind Exchange Considerations

Like with most tax provisions, there are rules dictating how 1031 exchanges may be utilized. There are also additional considerations that may guide a taxpayer’s decision. For example:

• A 1031 exchange can be done in reverse – Investors may identify and purchase the new property first before selling their current property. Termed a “reverse exchange,” a titleholder may be necessary to facilitate this transaction.
• Capital gains taxes are deferred, not eliminated – 1031 exchanges may delay capital taxes, but the bill comes due if the new property is ever sold without another 1031. However, if the property owner dies before the property is sold, the capital gains taxes are wiped out. As such, 1031 exchanges are a popular estate planning tool.
• There can be no conflict of interest along the way – The intermediary must not be personally or professionally connected to any party involved in the 1031 exchange. That includes family members, business partners, employees, or anyone who provides professional services to the investor (an attorney, accountant, banker, agent, etc.). Anyone who has served the investor in the previous two years in one of these capacities is also disqualified.
• Sometimes, it makes sense to just pay the tax – While 1031 exchanges can reduce tax liabilities, it may not be worth the time and money to execute one. It takes considerable organization and time, as well as multiple parties to see the process through. For some transactions, the math may not make sense. A trusted tax attorney can ascertain whether that’s the case or not.

A Reputable Tax Professional Can Help with a 1031 Like-Kind Exchange 

By tax provision standards, 1031 like-kind exchanges are straightforward and simple to report. However, they are not always straightforward to organize and execute. Deadlines can be tight, and there will be additional complexities if there are liabilities tied to the property.

A tax attorney or accountant (or better yet, both) can adjust for these factors and ensure their client stays on time. In fact, a tax attorney can help their clients 1031 exchange their property for an intermediary property that’s only held for a short time to facilitate a second exchange. These are advanced tax maneuvers that require a tax professional to manage properly.

If you’re interested in exploring 1031 exchanges, our team of CPAs and tax attorneys can assess your situation and determine whether a 1031 will provide a tax advantage.

By Harold "Hap" May, P.C. on April 26, 2024   /   The Legal Play Podcast   /   Leave a comment