...a CPA's random thoughts...
Section 1031 Exchanges Post TCJA
Section 1031 exchange. Odds are, many of you have heard of this tax deferral method. It used to be a method of deferring taxes if you invested gains from the sale of one tangible asset to another. Effective 2018, under TCJA, the rules are now quite different and apply ONLY to real property. Sorry, you can no longer use Sec. 1031 exchange for automobiles or other assets that are not real [estate] property.
In its most simplistic form, a Sec. 1031 exchange allows an investor or business to sell real property and reinvest the resulting proceeds (namely, gain) in a new property (or series of properties) for the purpose of DEFERRING the capital tax gain. Note, first off, that this is simply a DEFERRAL of taxes—NOT elimination. Secondly, very specific rules apply, including the new property (or properties) must have a value and basis at least equal to the previous property.
Why might you wish to utilize a Sec. 1031 exchange?
- You have a low basis, and the fair value is rather high
- Capital gain rates are high
- Application of the ACA 3.8% NII tax
- High amount of debt that must be paid off, and thus you need to maximize current cash flows
The most common type of Sec. 1031 exchange is a DELAYED exchange. Accordingly, that will be the entire focus of this discussion. A delayed exchange occurs when there is a timing difference between the sale and purchase of LIKE-TYPE REAL properties. Simply put, you have a maximum of 180 days after the sale of the initial old property to purchase replacement new property. This does not necessarily need to be a single parcel of real property, but certain regulations absolutely apply to still quality for a Sec. 1031 exchange.
Seven BASIC rules exist. Satisfying these seven basic rules does not mean you automatically quality for a Sec. 1031 exchange, but adherence to them certainly increases the likelihood you remain within IRC compliance and that the IRS will not challenge your position:
- Must be for like-kind property (real property for real property, more on that later)
- Must be for investment or for business use only—does not apply to personal residences or vacation homes that are NOT rented out as a legitimate Schedule E business
- Greater or equal value to old property, including basis
- You may NOT receive any sort of boot (cash, or cash equivalent)
- The old and new properties must be sold and acquired by the same taxpayer—you may not sell one property under one tax iD, and acquire new property under another if you expect to utilize Sec. 1031
- You have 45 days to identify at least one potential replacement piece of real property
- You have 180 days from date of sale of old property to close on the new property or properties (again, REAL property….AKA., REAL ESTATE!!!)
Rule #1 is very broad—it must be of the same nature and character, but the quality and nature may differ. You may not exchange a personal residence for a vacation property, but you may exchange a vacation rental property for another rental property, even if a commercial property. Conversely, you will be allowed to exchange a single-family residence used as a rental property for a commercial office building. Again, it is the character and nature of the real estate that matters.
Additionally, the market’s value and equity of the replacement real property must be at least equal to that of the old property. This may be achieved through a series of like type properties and does NOT have to consist of a single piece of real property.
You have 45 days from original date of sale to identify at least one prospective property of at least equal value d equity. A 200% rule exists in which you may use four or more properties to satisfy this requirement.
In conjunction with the 45-day identification regulation, you have 180 days to close on a property or series of properties that meet the criteria for a Sec. 1031 exchange.
You may be required to utilize a Qualified Intermediary to conduct such a transaction. Recently, I was asked to perform this function, but it is not part of my routine service offerings and, accordingly, I declined. Effectively, a Qualified Intermediary serves to facilitate the 1031 exchange process by not allowing you, as the taxpayer, to take possession and control of proceeds from the sale of an old property while identifying at least one new replacement, like-kind property. This Qualified Intermediary becomes involved in the acquisition process and is responsible for disbursing proceeds from the original sale. Such intermediaries may include CPAs and lawyers that have the authority, under state law, to handle and separately account for funds under a Trust account and associated regulations.
There are many more details in connection with a Section 1031 exchange, especially 2018 and forward. This discussion is ABSOLUTELY NOT all-inclusive, and your situation may be very unique. Accordingly, it is your responsibility for seek the counsel of legal and tax professionals to help assure your Section 1031 exchange will be honored by the IRS, instead of challenged.
Sincerely,
Greg Bennett, CPA