What is the 1031 “Like-Kind” Exchange and what has updated?

What is a 1031 “Like-Kind” Exchange Under the Prior Code?

A 1031 exchange, also known as a “like-kind exchange,” allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long another property of “like-kind” is purchased with the profit from by the sale of the first property.

4 Types of Like-Kind Exchanges:

1. Deferred or Delayed Exchange
2. Simultaneous Exchange
3. Reverse Exchange
4. Construction or Improvement Exchange

Deferred or Delayed Exchange – Most Common:

• A deferred exchange occurs when, pursuant to an agreement, a taxpayer transfers property to another party in exchange for a promise by that party to transfer like-kind property to the taxpayer on some future date.
• Assuming the 2 properties would otherwise qualify for a like-kind exchange, a deferred exchange will qualify for nonrecognition treatment so long as the 45-day identification and 180-day completion periods are both met.

Simultaneous Exchange

• Simultaneous exchanges allow for a mutual exchange of properties on the same day.
• This type of 1031 exchange is not common because it is unusual that both parties in the transaction (1) have the exact property the other party wants to receive; and (2) want to give up the exact property the other party wants to receive.

Reverse Exchange:

• In a Reverse Exchange, the replacement property must be purchased before the old property is sold—buying first and paying later.
• However, this type of exchange requires the property to be transferred to an Exchange Accommodation Titleholder (“EAT”), so that the taxpayer is not the actual property holder, just an interest holder.
• The property an EAT can hold either the replacement property or relinquished property.
• When the old property is sold, a simultaneous like-kind exchange will be completed when the relinquished property transaction is finalized.

Construction or Improvement Exchange:

• A taxpayer who desires to purchase a replacement property worth less than the property sold, may construct the ideal desired replacement property by making improvements it.
• Improvements must be constructed within the 180-day period and satisfy all of the other §1031 Exchange requirements.
• Improvements include: complex repairs or simple repairs to existing structures.

General Requirements for a Transaction to Qualify as a 1031 Like-Kind Exchange:

1. Property of “Like – Kind”: The property that the taxpayer gives up must be of like kind to that which the taxpayer receives—must be a property of the same nature, character or class.
2. Investment or Business Purpose: Both the property given up and the property received must be used for business or investment purposes. Neither property may be used for personal purposes.
3. Greater or Equal Value: In order to avoid paying taxes on the exchange, the replacement property must be in equal or greater value than the relinquished property.
4. Must Not Receive “Boot”: Any boot received is taxable to the extent of gain realized on the exchange. A taxpayer can still carry out a partial 1031 exchange where the new property is of lesser value, and the difference is called “boot”; the amount a taxpayer will have to pay capital gain taxes on.
5. Identification Period: The property to be received by the taxpayer in the exchange must be identified on or before the 45th day after the taxpayer transferred his property.
   • The property is considered “identified” before the end of the 45-day period only if the property is designated as the property to be received, in a written document signed by the taxpayer giving the property, and hand delivered, mailed, or facsimiled.
   • Exception to the delivery requirement à property to be received will be identified if there is a written agreement for the exchange of properties signed by all parties before the end of the 45-day identification period.
6. Purchase Period: The identified property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date of the income tax return for the tax year in which the property given was sold, whichever is earlier.
   • This 180-day completion period includes the 45-day identification period within it, so it’s a total of 180 days, not 45 days plus 180 days.

Previous 1031 and H.R.1 Changes (All changes in the new bill will be found in RED)

1031 Exchange of Real Property Held for Productive Use or Investment

(a) Nonrecognition of gain or loss from exchanges solely in kind. 

1. In general. No gain or loss shall be recognized on the exchange of [real] property held for productive use in a trade or business or for investment if such property is exchanged solely for [real] property of like kind which is to be held either for productive use in a trade or business or for investment.
2.         Exception. This subsection shall not apply to any exchange of…
   1. Stock in trade or other [real] property held primarily for sale;

(c) Effective Date (New Section Added)

1. In General -Except as otherwise provided in this subsection, the amendments made by this section shall apply to exchanges completed after December 31, 2017.
2. Transition Rule -The amendments made by this section shall not apply to any exchange if;
   1. the property disposed of by the taxpayer in the exchange is disposed of on or before December 31, 2017, or
   2. the property received by the taxpayer in the exchange is received on or before December 31, 2017.

(e) Exchanges on Livestock of Different Sexes [Stricken]

New Section

(e) Application to Certain Partnerships -For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.

(h) Special Rules for Foreign Real [And Personal] Property – For purposes of this section –

1. Real Property: Real property located in the United States and real property located outside the United States are not property of a like kind.
2. Personal Property [Stricken]

(i) Special Rules for Mutual Ditch, Reservoir, or Irrigation Company Stock. [Stricken]

Previous 1031 Exchange Hypothetical:

• Steve wants to sell his commercial property for its current value, $600,000, which he bought for $400,000 as an investment. Steve knows that selling his property will generate a $200,000 taxable.
• If Steve does a §1031 like-kind exchange for another commercial property worth $600,000, he can defer this capital gains tax by replacing the property with a “like-kind” property: another property that is similar in nature to the one he is selling → commercial property for commercial property.
• If Steve sells his property and more than 45 days go by without obtaining a replacement property, Steve may be subject to the capital gains tax.
• If Steve sells his property within the 45-day identification period and completes the exchange within the 180-day purchase period, Steve’s exchange will qualify under the §1031 Like-Kind Exchange rules for nonrecognition treatment.

New H.R. 1 1031 Exchange 

• The H.R. 1 repealed §1031 Exchanges for all other types of property that are not real property → personal property, collectibles, aircrafts, franchise rights, rental cars, trucks, heavy equipment, and machinery are no longer allowed after December 31, 2017.
• So in the hypothetical above, if Steve wants to receive nonrecognition treatment under the §1031 exchange rules, he is only allowed to exchange real property, used for business or investment purposes.

We here at EPGD Law are quite understanding of the fact that this can all be very confusing. If you’d like to know more about 1031 Like-Kind Exchange or believe you may have gone through a similar transaction and are not certain, we’re here to help. Our experienced attorneys are available for appointments by calling (786) 837 – 6787 or via email info@epgdlaw.com.

*Disclaimer: This blog post is not intended to be legal advice. We highly recommend speaking to an attorney if you have any legal concerns. Contacting us through our website does not establish an attorney-client relationship.*