The 1031 Exchange:
Section 1031 of the Internal Revenue Code provides an exception from the rule requiring the current recognition of gain or loss realized upon the sale or exchange of property. Under §1031(a), no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment. Section 1031 provides an exception only from current recognition of gain realized. The realized gain is deferred until the “exchange property” is disposed of in a subsequent taxable transaction. Stated another way, Section 1031 allows a taxpayer to postpone their long-term capital gains tax when selling an investment property by exchanging both the basis and the gain into a new investment property. A Section 1031 exchange defers the gain from the sale of an old investment property into the purchase of a new investment property.
The origins of Section 1031 date back to the Revenue Act of 1921. Recent years have seen a number of proposals aimed at eliminating or capping the Section 1031 exchange. In 2017, the House Republican Blueprint for Tax Reform, titled “A Better Way” is expected to be the model for tax reform. The proposal does not repeal Section 1031, neither does it expressly preserve the provision. Ernst & Young, LLP’s study of the Economic Impact of Repealing Like-Kind Exchange Rules found that the impact of repealing or limiting Section 1031 exchanges in 2015 would result in a contraction of the US economy if Section 1031 was repealed or limited. As a result of these proposals the window for recognizing the benefits of a Section 1031 exchange may be closing. Consider the following if you are thinking about a Section 1031 exchange in 2017:
Like Kind Property. Section 1031 cannot be used for personal property but is only available for investment and business property. The property must be like kind property. Like kind does not necessarily mean the same.
Delayed Exchanges. Historically, an exchange was a simple swap of one property for another between two parties. Following the Starker case, delayed exchanges were allowed. Now, the vast majority of exchanges are delayed, or three party exchanges. In a delayed exchange, a middleman, or qualified intermediary, holds the cash after the property is sold. The qualified intermediary then buys the replacement property for using the escrowed cash. Subject to time limits, this three-party exchange is treated as a Section 1031 exchange.
Timing. A delayed exchange has two principal timing rules. Once the sale closes, the qualified intermediary receives the cash. Within 45 days, the seller must specify the property in writing to the intermediary to be acquired. Once replacement property is designated, the seller must close on the replacement property within 180 days of the sale of the relinquished property. The 45 days and 180 days run concurrently.
Cash and Liabilities. Any leftover cash is distributed by the qualified intermediary at the end of the 180 days. That cash is called “boot” and is taxed, generally as a capital gain. Mortgage loans or other debt on the relinquished property must be replaced with equal debt on the replacement property. If the seller’s liabilities go down, the seller is treated as having received income just the same as cash.
Unless expressly provided that the advice (“the advice”) contained in the above (“this message”) is intended to constitute written tax advice within the meaning of Section 10.37 of IRS Circular 230, this message is intended to communicate general information for discussion purposes only, and you should not, therefore, interpret the advice to be written tax advice.