Buying & Selling Similar Properties? How to Defer Taxes on Like-Kind Exchanges
March 30, 2018
Ben, an investor in real estate, is curious about taxes on like-kind exchanges. He just finished renovations on an industrial building he has owned for years, transforming it into a modern, attractive office space.
Like most real estate speculators, Ben doesn’t plan on retiring after this project is sold. In fact, he wants to invest the proceeds in another round in the real game of Monopoly.
The question Ben wants answered: Do I really need to pay tax right now?
Fortunately for Ben and others like him, the IRS offers an increasingly popular escape hatch for those wishing to defer taxes on like-kind exchanges. Section 1031 allows investors to essentially postpone tax on proceeds from the sale of an asset if the money goes toward the purchase of something similar.
Before this year, Section 1031 applied to personal property as well as real estate. But under recent tax reform, personal property no longer qualifies for deferral under Section 1031.
Section 1031 is beneficial when used right. But it’s full of intricacies, special rules, and timing restraints that require strong tax knowledge and skillful planning. Here are some key points for Ben to consider, but he – and you — should talk with a CPA-led business advisory firm before attempting a 1031 exchange.
The proper treatment of cash is vital to successfully completing a 1031 exchange. This is important when wanting to defer taxes on like-kind exchanges.
Cash must not be directly received from the sale of the old asset. The cash from the sale must go to a qualified intermediary, who will hold it until the replacement asset is bought.
If the seller receives cash, then the transaction no longer qualifies for a 1031 exchange and is treated as a normal sale. Additionally, any cash left over after purchasing the replacement asset is considered “boot” and generally will be taxed as a capital gain. It’s important to consider the relief of liabilities that could potentially be considered “boot.”
Since 1984, there have been two timing restrictions placed on all 1031 exchanges. The timer for both restrictions start the day that the old asset is sold.
• First, the seller has 45 days to specify up to three replacement properties to buy, although the seller can designate more if they meet certain valuation tests. The replacement properties must be designated in writing to the intermediary before this 45-day limit expires.
• Second, you must close on 1031 replacement properties within 180 days.
Section 1031 is designed for investment and business property, so property “held for sale” doesn’t qualify.
When researching replacement properties, understand what the IRS means for properties to be “like-kind.” The language is very broad and has been applied in cases like an apartment building being exchanged for a warehouse, and a shopping center for a rental house.
Summary: Taxes on Like-Kind Exchanges
Ben and other real estate investors can exchange existing assets for new, with little or no current taxes on like-kind exchanges — with proper understanding of the 1031 requirements, and clear communication with tax and legal counsel.
This has been a fundamental code section for maximizing return on business and investment assets while deferring taxes to future years.
Like Ben, if you think a 1031 exchange can benefit you, contact a CPA-led business advisory firm to start the discussion.