The Section 1031 Like-Kind Exchange

Commercial Real Estate Toolkit

While there are many reasons to allocate a portion of your investment portfolio to real estate, the tax treatment of real estate held for business or investment purposes might be at the top of the list. Unlike any other investment, the U.S. Internal Revenue Code permits capital gains on the sale of real estate to be deferred indefinitely by completing a tax deferred like-kind exchange that qualifies under Section 1031 of the Internal Revenue Code. This means that real estate investors and businesses that own real estate can buy and sell real estate and delay or even entirely avoid paying any capital gains taxes by following the 1031 like-kind exchange rules.              

Although the 1031 exchange rules apply to an actual exchange of real property, most 1031 exchanges follow the rules for a deferred 1031 exchange. To accomplish a deferred 1031 exchange the taxpayer sells a property, the proceeds of the sale are placed directly into an account with a qualified intermediary often referred to as a 1031 exchange accommodator (the money cannot go into the seller’s account) and then within the specified time period, the taxpayer must buy a qualifying property to complete the exchange using the funds held by the qualified intermediary.    

The property sold and acquired must be used in a trade or business or held for investment purposes. Property held for personal use, such as a primary residence or second home does not qualify for like-kind exchange treatment.   

The property sold and the property acquired must be “like-kind.” Generally, any kind of real estate is like-kind to any other kind of real estate. For example, an apartment building is considered like-kind to an industrial building. However, one exception is that real property located outside the United States is not considered like-kind to real property inside the United States.

Two important time restrictions apply to a 1031 exchange. First, the taxpayer must identify the potential replacement property or properties no later than 45 days from the date the taxpayer sells its property. The identification must be in writing, signed by the taxpayer and delivered to the qualified intermediary. The replacement property must be clearly identified using a legal description or street address. Second, the taxpayer must purchase the replacement property no later than 180 days after the sale of the taxpayer’s 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. If the taxpayer identifies replacement properties within the 45-day period, the sale proceeds cannot be disbursed back to the taxpayer from the qualified intermediary until 180 days have passed, even if the taxpayer decides not to buy any of the identified properties.

The taxpayer must comply with the identification rules. A maximum of 3 replacement properties can be identified with any value, more than 3 replacement properties can be identified, but the total value of the identified properties cannot exceed two times the price of the property sold, or any number of properties can be identified regardless of value as long as at least 95% of the identified property is ultimately purchased.

The property or properties purchased, when combined, must meet certain value, debt, and equity requirements for 100% of the taxable gain to be deferred. The replacement properties purchased must be of equal or greater value than the property sold, the equity of the replacement property must be of equal or greater value than the equity of the property sold, and the debt secured against the replacement property must be of equal or greater value than the debt secured against the property sold. All net profit from the property sold must be used in the purchase of the replacement property.   

The taxable gains are deferred, not forgiven. After completing a 1031 exchange, the taxpayer’s cost-basis in the property sold transfers to the property purchased, so the cost-basis and depreciation deductions could be very low in the newly acquired property. If the taxpayer later sells the replacement property after completing a 1031 exchange and does not do a subsequent 1031 exchange with the proceeds, all of the taxable gains then become due. If, however, the taxpayer continues to complete 1031 exchanges for the taxpayer’s entire lifetime, upon death, the taxpayer’s heirs will take the property with a stepped up cost-basis, making permanent the deferral of capital gains taxes for the deceased taxpayer.

Advanced planning is a key component of completing a successful 1031 exchange. The 1031 exchange rules can be complicated which is why it is important to have an experienced commercial real estate attorney and qualified intermediary assist you with your 1031 exchange.