Like-kind exchanges were included in the Revenue Act of 1921 as part of the tax reduction package due to excess profits and preferential treatment for capital gains resulting from the War Revenue Act of 1917. IRS 1031 defers tax obligation until a replacement property is sold, unless another “exchange” occurs.
1031 will apply if the following requirements are met:
- Both the property to be relinquished and the property to be acquired must be like-kind
- Both the property to be relinquished and the property to be acquired must be held for business or investment purposes
- The transaction must be structured so that the taxpayer does not actually or constructively receive the proceeds of the sale which among other things require that a “qualified intermediary” be used for non-simultaneous exchanges (aka “Delayed”, or “Starker” Exchanges)
- The replacement property must be identified within 45 days of the sale and must be acquired within 180 days of the sale. Note that the IRS is very strict in not allowing any extensions of these time limitations.
The new property acquired in the exchange takes the basis of the old property, adjusted by the value of any “boot” (the money or the fair market value of other property received or given in the exchange). The boot itself is taxable to the extent of gain realized, at a normal capital gains rate.
- Tax deferral. The sale of a business or investment property could result in high capital gains taxes – taxes which can be deferred indefinitely if you reinvest in a replacement property within the prescribed time limits.
- Leverage and increased cash flow for reinvestment. With access to the entire proceeds of the sale, including the extra cash that would otherwise be used to pay capital gains taxes, an investor or business can make down payments on more properties.
- You can join a TIC. Participation as a Tenant-in-Common (TIC) allows an investor to diversify their holdings by owning a fractional interest in multiple properties along with up to 35 other investors, and still qualify for 1031 treatment when properties are exchanged.
- Opportunity to accumulate significant wealth over time. Investors who perform 1031 exchanges continually for many years may gradually build a significant portfolio and benefit from increased cash flow from numerous investment properties. They can eventually pass these properties on to their children, who may receive a step-up in basis at their death – resulting in no capital gains taxes through to the next generation.
- “Tax deferred” does not mean “tax free”. Unless an investor is planning on a lifetime of continuous investment with all exchanged property to eventually be passed on to their children, capital gains taxes will eventually come due. 1031 exchanges offer only tax deferral, not forgiveness of a tax debt. Also note that tax laws tend to change over time, as do taxes!
- Reduced basis in the new property. The replacement property will receive the basis of the relinquished property. If the exchange was made between depreciated properties, the same depreciation method and rate will be continued for the replacement property. If the exchanged property is subject to depreciation recapture, the depreciation that was previously claimed will be recaptured as ordinary income.
- Losses are not recognized. Like-kind exchanges are not at all useful in the event of a loss, because losses under 1031, like gains, are not recognized regardless of the amount of boot received. The investor or business will have to carry the loss forward as a higher basis in the property received.
- Many inflexible rules and regulations to follow. Here are just a few: You need to identify a replacement property within 45 days and close on the new property within 180 days. You can’t touch the proceeds (a Qualified Intermediary is required). You can’t flip a property or you risk the IRS claiming that you bought it for resale and not investment – in that case the IRS will assess taxes for ordinary income, not capital gain. Unless you rent them out and meet other requirements, you generally can’t do a 1031 exchange on a residence or vacation home. Related parties (family members and others sharing ownership or control) must hold an exchanged property for at least two years to qualify for tax deferral.
So, while there are benefits to the tax deferral inherent in a 1031, there is no guarantee that 1031 laws will not change, plus, regarding real estate exchanges, this asset is not very liquid and replacement properties are increasingly difficult to come by.
So how do you exit a 1031 investment property quickly and with minimal tax exposure? The answer lies in the War Revenue Act of 1917 enacted prior to the Act which enshrined the 1031. The War Revenue Act created the Charitable Tax Deduction (Section 170) with a little-known feature called a Bargain Sale.
What is an IRS Section 170 Bargain Sale?
- The buyer is a government approved charity or non-profit (501c3)
- The cash consideration is less than the fair market value of the asset
- The difference between the fair market value (based on an IRS 561 appraisal) and the cash consideration is tax deductible
- The financial benefits of the tax deduction plus the cash consideration can sometimes exceed or match an all-cash transaction
- Owner wants to do something charitable
If the cash consideration is equal to or less than the basis of the original exchange property, there are no taxes – that’s correct no recapture of depreciation or capital gains taxes. And if you can take advantage of the tax deduction, its benefit is as good as cash. If you would like to learn more: https://www.irs.gov/publications/p544#en_US_2016_publink100072279.