The IRS allows taxpayers to defer the payment of federal taxes on any gain associated with the exchange of property, provided the properties are “like-kind” in nature.
These transactions are commonly referred to as “like-kind exchanges” and are governed by Internal Revenue Code Section 1031. If structured properly, the gain that would have been taxed if the transaction was treated as a sale is deferred and potentially taxed when the replacement property is sold in the future.
Below are a few ways to help navigate the requirements, as well as planning tips on how to maximize the benefits of this provision.
A properly structured 1031 exchange has three separate requirements:
1. An exchange element
2. Property that is “like-kind”
3. Property that is either held for investment or used in a trade or business
To satisfy the exchange requirement, the transaction must involve a direct property-for-property transfer. A sale of the property for cash followed by an immediate reinvestment of the proceeds into similar property does not constitute a qualified exchange. Many like-kind exchanges involve the use of a third-party qualified intermediary, commonly referred to as a QI. Using a QI provides taxpayers additional flexibility with respect to the identification and acquisition of the replacement property.
The definition of “like-kind” property is very broad. Generally, real property can only be exchanged for other real property. Generally, personal property (furniture, equipment, etc.) can only be exchanged for other personal property. A building exchanged for a machine is not “like-kind.” The most common type of personal property like-kind exchange involves a company trading in an older vehicle in exchange for a newer vehicle.
Lastly, Section 1031 requires the exchanged properties to be either held for investment or used in a trade or business. Thus, this requirement would be violated if either property in the exchange is inventory, property under development, personal assets or a partnership/LLC interest. The classification of property is based on facts and circumstances as several court cases have focused on the intent of the taxpayer when the property was originally purchased. As a result, in order to meet the third requirement, the taxpayer’s intent of use upon purchase should be well documented.
Section 1031 remains one of the most powerful provisions in the tax code. There are countless ways to utilize this law to a taxpayer’s benefit. If structured properly, Section 1031 can help to fully maximize the investment goals of the taxpayer, while also minimize potential tax liability.