Usually, selling a business or an investment property and then using its proceeds to buy a similar property becomes a taxable transaction. However, there is a way to avoid that and that is by allowing a Sec 1031 – Like Kind Exchange.
What is a Sec 1031- Like Kind Exchange?
It is a simultaneous swap of one business or investment property for another. No gain or loss is recognized when real property such as land, buildings, apartment buildings, commercial property, machinery, canals, ponds or any property used in trade for business and investment purposes is exchanged for like-kind property that is used for trade in business or for investment purposes. Typical examples that qualify for a like-kind exchange are a shopping mall for an office building, an apartment complex for a commercial office building, a rental house in Dallas, TX for another rental house in Orlando, FL, an office building in San Francisco, CA for a commercial storage space in New York City, NY, restaurant space for an office space so on and so forth.
As a special mention, Real property and Personal Property both qualify for a like-kind exchange though Real property and Personal property can never be like-kind to each other.
Also, personal homes, fix-and-flip properties, vacation homes or second homes( unless used for rentals), land under development or any property held for resale do not qualify for a Sec 1031-Like Kind exchange. Inventory, stocks, bonds, other securities, certificates of trust, partnership interest also do not qualify for like-kind exchanges. An exchange for property located within United States for a property that is located outside of United States is an invalid exchange and is not recognized.
Who qualifies for a Sec 1031-Like Kind Exchange?
Individuals, S-Corporations, C-Corporations, Partnerships( both general and limited), Limited Liability Corporations(LLCs) and any other tax paying entity is eligible for a Sec 1031-Like Kind exchange, assuming that one business or investment property is being exchanged for another similar business or investment property.
Deadlines for completing a Sec 1031- Like Kind Exchange
In a section 1031-Like Kind exchange, the property that is given up needs to be identified within 45 days after the date of its transfer. Also, the replacement property in a deferred exchange must be received either before the 180th day after the date on which the property was transferred or before the due date( including extensions) of the investor’s tax return for which the year in which the transfer of that property occurs, which ever is earlier. The IRS is strict with deadlines and the only exception made is in the case of presidential declared natural disaster areas.
Benefits of a Sec 1031- Like Kind Exchange
Major advantage of Like-kind exchanges is that they avoid immediate tax consequences unless cash is received in exchange. They postpone paying taxes on any gains made. They also avoid depreciation recapture.
By utilizing the money that the investor would have paid to the IRS in taxes, he/she can increase their down payment and improve their overall buying power to acquire a more expensive replacement property. This increases leverage and cash for the investor.
The investor can consolidate multiple properties into one. For example, he can exchange a two duplex rental for an office space. Sec 1031- Like Kind Exchanges are generally done if an investor does not want to pay capital gains taxes. Like Kind exchanges have stringent time and monetary requirements. Read the article to see what those requirements are.
High maintenance properties can be replaced with low maintenance ones thereby reducing operational and management efforts. 1031 exchanges might also result in increased cash flow such as when a 10 apartment rental building is replaced with a 100 apartment rental complex.
Related party transactions are allowed as well. More on it to follow in Paper No. 2.
Like-Kind exchanges also take place when an investor wants his/her portfolio to consist of only low maintenance properties or perhaps he/she made a wrong investment that is not profitable or not yielding high returns.
In a nut shell, if carried out correctly, a Like-Kind Exchange is an effective tax deferment and investment strategy as well as an estate planning tool.
Where to report a Sec 1031- Like Kind exchange?
The IRS requires Form 8824- Like Kind Exchange to be filled in and attached to the taxpayer’s/investor’s return and be filed with the tax return in the year in which the exchange occurred.
GavTax Advisory Services accepts clients from all 50 States including the State of New York, California, Texas, Illinois, Florida, Pennsylvania, Ohio, New Jersey, Virginia, North Carolina and all U.S territories as well.