1031 Exchange – Investment Properties
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. 1031.org
In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction.
Frequently Asked Tax Questions And Answers – From IRS Site
No. A deferred exchange will be treated as a sale rather than a tax free exchange if the taxpayer actually or constructively receives money on other property in full consideration of the relinquished property. However, rental property may be exchanged directly for other rental property of like kind. Gain realized from such an exchange is deferred. For additional information on like-kind exchanges, refer to Publication 544, Sales and Other Dispositions of Assets.
References: Publication 544, Sales and Other Dispositions of Assets
I have heard that I can sell my rental property and use the proceeds to purchase rental property of equal or greater value and the transaction is viewed just like an exchange in that the tax is deferred until the new property is sold. Is this true?
What you have heard about is a like-kind exchange. A like-kind exchange, when properly executed, represents a way to postpone the recognition (taxation) of gain essentially by shifting the basis of old property to new property. If, in addition to giving up like-kind property, you pay money in a like-kind exchange, you still have no recognized gain or loss. The basis of the property received is the basis of the property given up, increased by the money paid. There are several rules and restrictions that must be strictly adhered to in order for a successful exchange to take place. Deferred exchanges will be treated as a sale rather than an exchange to the extent that the taxpayer actually or constructively receives money or other (not like kind) property in exchange for the like-kind property given up. For more information refer to .Publication 544, Sales and Other Disposition of Assets , and Form 8824 (PDF) Instructions, Like-Kind Exchanges . Form 8824 (PDF), Instructions, Like Kind Exchanges
We sold a rental property last year and used the 1031 Tax Deferred Exchange law to defer the gain into another like-kind property. How do I report this transaction on my tax return?
Report the exchange of like-kind property on Form 8824 (PDF), Like-Kind Exchanges. The instructions for the form explain how to report the details of the exchange. Report the exchange even though no gain or loss is recognized.
If you have any taxable gain, resulting from the transaction, because you had a partially deferred exchange or otherwise received money or unlike property, report it on Form 4797 (PDF), Sale of Business Property, and Form 1040, Schedule D (PDF), Capital Gains and Losses. Refer to Publication 544, Sales and Other Dispositions of Assets, which has a detailed section on qualifying like-kind exchanges. Publication 544, Sales and Other Dispositions of Assets
Like Kind Property
The exchange of property for the same kind of property is the most common type of nontaxable exchange. To be a like-kind exchange, the property traded and the property received must be both of the following.
- Qualifying property.
- Like-kind property.
These two requirements are discussed later.
Additional requirements apply to exchanges in which the property received is not received immediately upon the transfer of the property given up. See Deferred Exchange, later.
If the like-kind exchange involves the receipt of money or unlike property or the assumption of your liabilities, you may have to recognize gain. See Partially Nontaxable Exchanges, later.
You exchanged real estate held for investment with an adjusted basis of $25,000 for other real estate held for investment. The basis of your new property is the same as the basis of the old ($25,000).
For the basis of property received in an exchange that is only partially nontaxable, see Partially Nontaxable Exchanges, later.
Bill Smith trades an old cab for a new one. The new cab costs $30,000. He is allowed $8,000 for the old cab and pays $22,000 cash. He has no recognized gain or loss on the transaction regardless of the adjusted basis of his old cab. If Bill sold the old cab to a third-party for $8,000 and bought a new one, he would have a recognized gain or loss on the sale of his old cab equal to the difference between the amount realized and the adjusted basis of the old cab.
You used your car in your business for 2 years. Its adjusted basis is $3,500 and its trade-in value is $4,500. You are interested in a new car that costs $20,000. Ordinarily, you would trade your old car for the new one and pay the dealer $15,500. Your basis for depreciation of the new car would then be $19,000 ($15,500 plus $3,500 adjusted basis of the old car).
You want your new car to have a larger basis for depreciation, so you arrange to sell your old car to the dealer for $4,500. You then buy the new one for $20,000 from the same dealer. However, you are treated as having exchanged your old car for the new one because the sale and purchase are reciprocal and mutually dependent. Your basis for depreciation for the new car is $19,000, the same as if you traded the old car.
In a like-kind exchange, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Machinery, buildings, land, trucks, and rental houses are examples of property that may qualify.
The rules for like-kind exchanges do not apply to exchanges of the following property.
- Property you use for personal purposes, such as your home and your family car. However, see below.
- Stock in trade or other property held primarily for sale, such as inventories, raw materials, and real estate held by dealers.
- Stocks, bonds, notes, or other securities or evidences of indebtedness, such as accounts receivable.
- Partnership interests.
- Certificates of trust or beneficial interest.
- Choses in action, such as a lawsuit in which you are the plaintiff.
- Certain tax-exempt use property subject to a lease. For more information, see section 470(e) of the Internal Revenue Code.
However, you may have a nontaxable exchange under other rules. See Other Nontaxable Exchanges, later.
A dwelling unit (home, apartment, condominium, or similar property) may, for purposes of a like-kind exchange, qualify as property held for productive use in a trade or business or for investment purposes if certain requirements are met. See Revenue Procedure 2008-16, 2008-10 I.R.B. 547, available at www.irs.gov/irb/2008-10_IRB/ar12.html.
An exchange of the assets of a business for the assets of a similar business cannot be treated as an exchange of one property for another property. Whether you engaged in a like-kind exchange depends on an analysis of each asset involved in the exchange. However, see Multiple Property Exchanges, later.
There must be an exchange of like-kind property. Like-kind properties are properties of the same nature or character, even if they differ in grade or quality. The exchange of real estate for real estate and the exchange of personal property for similar personal property are exchanges of like-kind property. For example, the trade of land improved with an apartment house for land improved with a store building, or a panel truck for a pickup truck, is a like-kind exchange.
An exchange of personal property for real property does not qualify as a like-kind exchange. For example, an exchange of a piece of machinery for a store building does not qualify. Also, the exchange of livestock of different sexes does not qualify.
What are the time limits to complete a Section 1031 Deferred Like-Kind Exchange?
While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.
The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above. Learn More⇒Our prior page on 1031 exchange IRS.Gov
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Like Kind Exchanges are discussed starting on Page 11