A like-kind exchange under United States tax law, also known as a 1031 exchange, is a transaction or series of transactions that allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the sale of the first asset. In current law (post-2017), section 1031 applies only to exchanges of real property held for productive use in a trade or business or for investment. [1] [2] [3] Like-kind exchanges have been characterized as tax breaks or "tax loopholes". [4]
This kind of transaction is also called a "1031 exchange", because Internal Revenue Code section 1031 allows owners of certain kinds of assets to defer capital gains taxes on an exchange of like-kind properties. Both the relinquished property and the acquired property must be like-kind real property, and must be held for business or investment purposes. [5] The sum of the values on each side of the exchange need not be equal; if a taxpayer receives cash or other non-like-kind property (boot), gain is recognized to the extent of the boot. [6] Taxes on capital gains are not charged upon the disposition if a qualifying replacement property is acquired and the transaction otherwise meets the requirements. The transaction has to be properly structured, including that the taxpayer cannot be deemed to have actually or constructively received the sales price of the relinquished property; safe harbors address use of a qualified intermediary, escrow, or trust to avoid constructive receipt. [7] [8] The replacement property generally must be "identified" within 45 days after the transfer of the original property and must be "acquired" within 180 days of that transfer. [9] If the transaction is handled properly, the payment of tax is deferred until the replacement property is later sold without reinvestment in qualifying property.
The idea behind this section of the tax code is that when an individual or a business sells a property to buy another, no economic gain has been achieved; there has simply been a transfer from one property to another. For example, if a real estate investor sells an apartment building to buy another one, the investor will not be charged tax on any gains realized on the original apartment building to the extent the transaction qualifies and no boot is received. When the investor sells the original apartment building and purchases a new one, the value used from the original to buy the new one has not changed – the only thing that has changed is where the value resides.
A like-kind exchange is a type of "non-recognition provision". According to section 1001(c) of the Internal Revenue Code, all realized gains and losses must be recognized "except as otherwise provided in this subtitle". A like-kind exchange is one of the qualified exceptions, serving as the proto-typical "non-recognition provision".
Non-recognition is conferred on a like-kind exchange on the basis that the form of the taxpayer's investment changes while the substance of the investment does not. In a like-kind exchange, the realized gain or loss usually never disappears; rather, the unrecognized gain or loss typically carries over into the new asset. When the new asset is sold or exchanged in a taxable transaction, the realized gain or loss from the first transaction will then be recognized.
Several requirements must be met in a like-kind exchange to ensure that tax liability is not created upon the sale of the first asset:
The property or asset being sold ("old property") must be held for investment or use in a trade or business, and cannot be a personal residence. [10] The property or asset being purchased with the proceeds ("new property") must be like-kind real property to the old property (post-2017 limitation to real property). [11] The proceeds from the sale must be used to purchase the new property within 180 days of the sale of old property, and the new property must be identified within 45 days of the sale. [12] The investor cannot be in "constructive receipt" of the money from the sale of the old property; safe harbors include use of a qualified intermediary, qualified escrow, or qualified trust. [13]
One critical issue in a like-kind exchange is defining "property of like kind." The statute does not provide a comprehensive definition. Treasury Regulation § 1.1031(a)-1(b) explains that "like kind" refers to the "nature or character" of the property and not its grade or quality; improved and unimproved real estate are of like kind to each other. [14]
Prior to 2018, exchanges of certain personal and intangible property could also qualify under §1031, with additional rules in Treasury Regulation § 1.1031(a)-2. [15] For intangible property (and personal property not subject to depreciation), the general "nature or character" test applied. While livestock could qualify for like-kind exchange treatment, livestock of different sexes did not (and do not) qualify as like kind. [16] Section 1031 also provides that U.S. and foreign real property are not like kind to each other. [17] After the Tax Cuts and Jobs Act (TCJA), §1031 applies only to exchanges of real property; the Treasury’s final regulations supply a definition of "real property" and address incidental personal property received with real property. [18] [19]
Before 2018, seven categories of property were expressly ineligible for like-kind exchange treatment under then-applicable law (e.g., stock in trade, stocks, bonds, partnership interests, etc.). Since 2018, the limitation of §1031 to real property effectively supersedes most prior personal-property eligibility discussions, although the statutory foreign-property limitation continues to apply. [20] [21]
The unrecognized gain or unrecognized loss from a like-kind exchange is preserved in the new property received in the exchange. New property generally receives the basis of the old property, adjusted in value for any other property given or received in the exchange (see below for further discussion of "boot"). [22]
The taxpayer's basis in the new property is determined by starting with the taxpayer's basis in the old property exchanged. Adjustments are then made as needed to account for other property that may be received in the exchange. By using the taxpayer's basis in the old property as the reference point for the new property's basis, unrecognized gain or loss is preserved. [23]
By way of example, let's say a taxpayer exchanges an old asset worth $20,000 in which the taxpayer had a basis of $14,000 for a like-kind asset. Assuming the exchange qualifies for non-recognition (based on how the taxpayer held the old property and how the taxpayer intends to hold the new property), the $6,000 realized gain will not be recognized, and the taxpayer's basis in the new asset will be $14,000. Because the new asset likely has a value of $20,000 (in an arms'-length transaction the two assets would be deemed to have equal values), the $6,000 unrecognized gain is preserved in the new asset. Thus, in any like-kind exchange, the exact amount of any unrecognized gain or loss is preserved in the basis of the asset acquired in the exchange. [24]
Sometimes taxpayers participating in a like-kind exchange receive cash or other property in addition to the like-kind property. This non-like-kind property is referred to as "boot" (from the phrase "to boot"). When that occurs, the taxpayer has not received solely like-kind property. A "ceiling rule" in section 1031 provides that gain is recognized, but only to the extent of the amount of boot received. [25] [26]
For example, let's say a taxpayer receives like-kind property worth $12,000 and $8,000 in cash in exchange for old property with a basis of $14,000. The basis in the new property is determined by subtracting the cash received ($8,000) from the basis in the old property ($14,000) and then adding the gain recognized ($6,000). Thus, upon a cash sale of the new property for its fair market value of $12,000, no gain or loss would result. [27]
Property transferred in a like-kind exchange is often encumbered by liabilities and debt, especially where the asset is real estate. In this regard, the regulations treat relief from indebtedness as additional cash boot in a like-kind exchange; assumption of a taxpayer's liability is treated as money received by the taxpayer. [28]
For instance, let's say a taxpayer has an asset worth $20,000 and a basis of $8,000 with a debt in the amount of $4,000. The taxpayer trades the asset in exchange for like-kind property worth $16,000, and the other party to the exchange expressly assumes the $4,000 liability. The other party will be unwilling to pay any extra consideration in this transaction, because the taxpayer is receiving $16,000 of equity (property worth $20,000 but subject to a debt of $4,000) in exchange for property worth $16,000. No extra consideration should be paid.
The receipt of a boot will trigger recognition of gain when gain is realized on the exchange of the original asset, as shown above. A boot does not trigger recognition when a loss is realized.
For example: Ashley trades in a business truck with an adjusted basis of $27,000 for another business truck worth $18,000 plus $2,000 of cash. Ashley realizes a $7,000 loss which is all deferred and no gain or loss is recognized. The $2,000 cash only makes a difference in calculating realized, not recognized loss.
While taxpayers generally prefer non-recognition for realized gains (so they do not have to recognize the gain currently and pay the resulting federal income tax currently), they usually prefer to recognize realized losses currently in order to obtain the tax benefit of the resulting deduction sooner. That means a like-kind exchange is bad news in the case of a realized loss. None of the loss will be recognized regardless of the boot received. [29]
Section 267(a) of the tax code disallows deductions for losses resulting from sales to related persons. However, the basis of the property received by the taxpayer in a like-kind exchange with a relative is governed by section 1031. In other words, the taint of disallowance under section 267 does not carry over to the new asset. The loss is preserved in the basis of the new property when the new property is sold.
In many cases, two parties are unable to complete a like-kind exchange alone. For instance, one party may not wish to receive like-kind property or may wish to recognize loss on property that has declined in value. The two parties may involve a third party willing to pay cash. When a third party willing to pay cash is involved, Revenue Ruling 77-297 indicates that non-recognition will apply if the taxpayer acquires the new property solely for the purpose of exchanging it with property of a like kind. [30]
In Starker v. United States , the Ninth Circuit held that a taxpayer was entitled to section 1031 non-recognition upon the ultimate receipt of like-kind property, even though the taxpayer had already transferred the property to the buyer and had an extended period to identify replacement property. Congress responded by imposing statutory and regulatory time limits on the identification and receipt of replacement property. [31] Today, taxpayers must identify the replacement property within 45 days of the transfer of the relinquished property and must receive the replacement property within 180 days. [32] The IRS has also provided a safe harbor for certain reverse exchange "parking" arrangements in which an accommodation titleholder holds property temporarily for the taxpayer. [33]
Due to periodic changes to the tax code, as well as detailed regulations that contain a number of technical requirements, it is important to check the most current rules and regulations before proceeding with a like-kind exchange. Current rules require taxpayers to report exchanges on Form 8824, Like-Kind Exchanges, filed with the tax return for the year of the exchange; the instructions provide details on identification and exchange dates, relationships between parties, gain deferral, and basis computations. [34] [35]
As of 2013, expansion and exploitation by major corporations of like-kind exchanges, originally intended to relieve family farmers of capital gains tax when swapping land or livestock, to avoid taxes was cited by The New York Times as an example of the need for tax reform. [4]
With hundreds of thousands of transactions a year, it is hard to gauge the true cost of the tax break for so-called like-kind exchanges, like those used by Cendant, General Electric and Wells Fargo.
Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems & Materials. 2nd edition. American Casebook Series, Thomson West: St. Paul, Minnesota, 2007, 558–571.