Since 1921, Federal tax law under Internal Revenue Code (IRC) section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes, which otherwise would have been due from the sale, are thus deferred. These can range from relatively simple transactions involving commercial, agricultural and rental real estate to more complex transactions involving aircraft, trucks, trailers, containers, railcars, agricultural equipment, other heavy equipment, livestock and other assets. Most 1031 Exchanges involve separate buyers and sellers and are not simple swaps between two parties. Under these circumstances, tax rules require the use of an independent third party Qualified Intermediary (QI). The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. 1031 Exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property.
Like Kind Exchanges, also known as tax-deferred exchanges, are defined by IRC section 1031. Since 1921, section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes which otherwise would have been due from the sale are thus deferred. Section 1031 transactions range from 2-party “swaps” to more complex non-simultaneous 1031 Exchanges involving separate buyers and sellers. Qualifying assets include commercial, agricultural and rental real estate. Tax rules for non-simultaneous exchanges require the use of an independent third party Qualified Intermediary (QI). The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. Section 1031 Exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property.
All businesses, manufacturers, real estate investors, companies in the construction, trucking, rail, marine and equipment leasing industries, farmers, ranchers, individuals and more make good use of like-kind exchanges. 1031 Like-Kind Exchanges are one of the few incentives available to and used by taxpayers of all sizes. A recent industry survey showed that 60% of exchanges involve properties worth less than $1 million, and more than a third are worth less than $500,000. Qualified Intermediaries (QI) facilitate non-simultaneous tax-deferred exchanges of investment and business use properties for taxpayers of all sizes, from individuals of modest means to high net worth taxpayers and from small businesses to large entities.
Following a like-kind exchange, the business or investor is left with more working capital and can roll that money back into the business. The economy benefits because the business owner cannot receive a tax deferral benefit without reinvesting those savings back into the business, so businesses are encouraged to expand or upgrade their properties, machinery, equipment and other assets. Since properties located or used within foreign countries are not like-kind to assets in the United States, section 1031 promotes reinvestment and job growth within our US borders.
With 1031 Exchanges, taxes are deferred but not eliminated. These legitimate transactions utilize an important tax planning tool. Payment of tax occurs:
- Upon sale of the replacement asset;
- Incrementally, through increased income tax due to foregone depreciation; or
- By inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.
Section 1031 has remained in the tax code since 1921, notwithstanding repeated Congressional scrutiny, because it is based on sound tax policy that is predicated on continuity of investment by the taxpayer.
- Section 1031 is consistent with goals of efficiency, neutrality, fairness, and simplicity within the tax system.
- Section 1031 promotes business decisions that stimulate US job creation and growth of the US economy.
- Section 1031 promotes efficient use of productive capital and operating cash flow.
- Section 1031 exchanges facilitated by Qualified Intermediaries are neither abusive nor administratively difficult for either the IRS or taxpayers.
- Section 1031 benefits and is widely used by a broad spectrum of taxpayers at all levels, in all lines of business, including individuals, partnerships, limited liability companies, and corporations
Having nothing at all to do with footwear, “Boot” is a term that refers to the items of personal property and/or cash that are necessary to even out an exchange. Boot is property that is received in an exchange but is not “like-kind” as to other property acquired in an exchange transaction. Boot is defined as the “fair market value” of the non-qualified property received in an exchange.
While the receipt of boot will not disqualify the exchange, an Exchanger who receives boot in an exchange transaction generally recognizes gain to the extent of the value of the boot received. Some common examples of Boot are: Cash proceeds an Exchanger takes from escrow/settlement before the remaining proceeds are sent to the Qualified Intermediary;
- Exchanger’s cash proceeds remaining after the exchange;
- Nonqualified property, such as stocks, bonds, notes, or partnership interests;
- Proceeds taken from the exchange in the form of a note or contract for sale of the property. An Exchanger can utilize IRC §453 to recognize the gain (boot) of a seller carry-back note received in an exchange transaction under the installment sale rules (See Brief Exchange “Combining Seller Financing with Tax Deferred Exchanges” for ways to use the Note to defer taxable gain into the Replacement Property.);
- Relief from debt on the Relinquished Property caused by the assumption of a mortgage, trust deed, contract, or an agreement to pay other debt that is not replaced on the Replacement Property;
- Property that is not “like-kind”.
- Property that is intended for personal use and not for use by the Exchanger as either his/her investment or business use property.
To avoid the receipt of Boot, the Exchanger should:
- Purchase “like-kind” Replacement Property with a value equal to or greater than the value of the Relinquished Property;
- Reinvest all of the net equity (exchange funds) from the sale of the Relinquished Property in the purchase of the Replacement Property; and
- Make sure the debt on the Replacement Property is equal to or greater than the debt on the Relinquished Property. Exception: A reduction in debt on the Replacement Property can be offset with additional cash from the Exchanger, but increasing the debt on the Replacement Property cannot offset a reduction in the exchange equity, thereby resulting in excess exchange funds upon the completion of the exchange. Any excess exchange funds will be Boot and the capital gain tax will be due on the Boot received.
If you find a replacement property that you would like to acquire before you sell your current property, you can utilize a Reverse Exchange to maximize your tax deferral. If you would like to build on or make improvements to a replacement property, you can use the exchange proceeds by structuring an Improvement (Build-to-Suit or Construction) Exchange. Also known as “parking” transactions, both Reverse and Improvement Exchanges are two of the more complex yet highly useful exchange structures available.
For an exchange to satisfy IRC §1031, the taxpayer that will hold the title to the Replacement Property must be the same taxpayer that held title to the Relinquished Property. However, business considerations, liability issues, and lender requirements may make it difficult for the Exchanger to keep the same vesting on the Replacement Property. Exchangers must anticipate these vesting issues as part of their advanced planning for the exchange.
Since 1984, IRC §1031 has specifically excluded exchanges of partnership interests from non-recognition treatment. Thus, §1031 does not apply to an exchange of interests in a partnership regardless of whether the interests exchanged are general or limited partnership interests or are interests in the same partnership or in different partnerships, even if both partnerships own the same kind of real property.
There is a two-pronged test for properties to qualify for IRC §1031 tax-deferral treatment.
- Both the Relinquished and the Replacement Properties must be held by the Exchanger either for investment purposes or for productive use in a trade or business. The Exchanger’s purpose and intent in holding the property is the critical test. The use of the property by other parties to the exchange (Relinquished Property buyer or Replacement Property seller) is irrelevant.
- The Relinquished and the Replacement Properties must also be “like-kind.” The term “like-kind” refers to the nature or character of the property, ignoring differences of grade or quality. For example, unimproved real property is considered like-kind to improved real property, because the lack of improvements is a distinction of grade or quality; the basic real estate nature of both parcels is the same. Treas. Reg. §1.1031(a)-1(b). In essence, all real property in the United States is “like-kind” to all other domestic real property.
IRC § 1031(a)(2) specifically provides that real property held primarily for sale does not qualify for tax deferral under section 1031.
Following are examples of qualifying properties that could be exchanged:
- Raw land or farmland for improved real estate
- Oil & gas royalties for a ranch
- Fee simple interest in real estate for a 30-year leasehold or a Tenant-in-Common interest in real estate
- Residential, Commercial, Industrial or Retail rental properties for any other real estate
- Rental ski condo for a three-unit apartment building
- Mitigation credits for restoring wetlands for other mitigation credits
Under IRC §1031, the following properties do not qualify for tax-deferred exchange treatment:
- Stock in trade or other property held primarily for sale (i.e. property held by a developer, “flipper” or other dealer)
- Securities or other evidences of indebtedness or interest
- Stocks, bonds, or notes
Certificates of trust or beneficial interests
- Interests in a partnership
- Choses in action (rights to receive money or other property by judicial proceeding)
- Foreign real property for U.S. real property
- Goodwill of one business for goodwill of another business
The tax deferred exchange, as defined in §1031 of the Internal Revenue Code, offers taxpayers one of the last great opportunities to build wealth and save taxes. By completing an exchange, the Taxpayer (Exchanger) can dispose of investment or business-use assets, acquire Replacement Property and defer the tax that would ordinarily be due upon the sale.
To fully defer the capital gain or recapture tax, the Exchanger must:
(a) acquire “like kind” Replacement Property that will be held for investment or used productively in a trade or business,
(b) purchase Replacement Property of equal or greater value,
(c) reinvest all of the equity into the Replacement Property, and
(d) obtain the same or greater debt on the Replacement Property. Debt may be replaced with additional cash, but cash equity cannot be replaced with additional debt. Additionally, the Exchanger may not receive cash or other benefits from the sale proceeds during the exchange.
Effective January 1, 2018, IRC §1031 applies only to real estate assets. It does not apply to exchanges of stock in trade, inventory, or property held for sale, such as property acquired and developed or rehabbed for purposes of resale.
An exchange is rarely a swap of properties between two parties. Most exchanges involve multiple parties: the Exchanger, the buyer of the Exchanger’s old (Relinquished) property, the seller of the Exchanger’s new (Replacement) property, and a Qualified Intermediary. To create the exchange of assets and obtain the benefit of the “Safe Harbor” protections set out in Treasury Regulations 1.1031(k)-1(g)(4) which prevent actual or constructive receipt of exchange funds, prudent taxpayers use a professional Qualified Intermediary
Like-kind exchanges contribute to the velocity of the economy and promote job growth within the United States. §1031 stimulates the economy, encouraging real estate transactions, and encouraging companies to replace and upgrade machinery and equipment, stimulating purchases and sales of machinery, equipment, railcars, aircraft, trucks and other vehicles sooner, because tax on the gain can be deferred.
Owners of personal property assets used predominantly in the United States may only obtain tax deferral benefits by reinvesting in like-kind domestic assets. An energy company, for example, cannot receive tax deferral benefits for selling mining, gas and oil field machinery in Texas and moving their production activity to Canada. §1031 provides a strong incentive to multinational companies to maintain and increase investments in the US.
Transactional activity results in taxable income, job growth, manufacturing, financial services, construction, improved neighborhoods and tax revenue to states and local communities. Ultimately, this economic stimulus spills over to create jobs in factories, restaurants, recreational, hospitality, tourism and other local small businesses that generate revenue from the after tax dollars of employed workers.
For all businesses, section 1031 permits efficient use of productive capital and cash flow while allowing taxpayers to shift to more productive like-kind property, change geographic locations, diversify or consolidate holdings, or otherwise transition to meet changes in business needs or lifestyle. Tax-deferred exchanges provide an important stimulus to a multitude of economic sectors, having local, national and global effect.
Farmers and ranchers use 1031 Exchanges to combine acreage or acquire higher grade land or otherwise improve the quality of the operation. Retiring farmers are able to exchange their most valuable asset, their farm or ranch, for other real estate without diminishing the value of their life savings.
Section 1031 is used to promote conservation and environmental policies. Grants of conservation easements can be structured as tax-deferred exchanges, facilitating government and privately funded programs designed to improve water quality, reduce soil erosion, maintain wetlands and sustain critical wildlife habitat. These exchanges also enable landowners to acquire replacement farm or ranchland in less environmentally sensitive locations.
When a depreciated asset is exchanged under section 1031, the taxable gain / depreciation recapture is not recognized, but rather is rolled into the new asset. Depreciation is only allowable for any remaining tax basis and for value representing additional capital investment into a like-kind asset. For example, a company vehicle has a fair market value of $10,000, but it is fully depreciated. It has a tax basis of $0 and depreciation recapture gain of $10,000 at the time of sale. If it was exchanged for a replacement vehicle at a cost of $10,000, that replacement vehicle would have the same tax characteristics and no further depreciation would be allowed. If the replacement vehicle cost $25,000, then only $15,000, representing the additional investment, would be available for additional depreciation over a new tax life. If the relinquished company vehicle was not fully depreciated, but had a remaining tax basis of $2,000, and the new vehicle cost $25,000, then the maximum depreciation allowed on the replacement vehicle would be $17,000 (remaining tax basis plus additional investment).
The total depreciation expense allowed over the life of an asset which participates in an exchange or an ongoing exchange program is no greater than the depreciation expense of an asset that does not participate in an exchange or exchange program. Section 1031 benefits the taxpayer by permitting immediate reinvestment of the entire amount of sale proceeds back into the business, rather than impacting cash flow by forcing that taxpayer to recoup that capital investment slowly, over a multi-year depreciation schedule. Essentially, it provides a cash flow timing benefit.
Over the tax life of a depreciable asset, the dollar impact of section 1031 to the US Treasury is zero.
Vice President of Investment Sales
SVN - Rich Investment Real Estate Partners
"We are all about opening relationships, not just closing transactions."