Decoding the 1031 Exchange

Tired of your current rental property, but don’t want to pay income taxes on the sale? Thinking of trading your old business car in for a new one? Looking for less time committed to managing your rentals?

Your answer may be a like-kind exchange (also known as 1031 exchanges and Starker Exchanges).

In order to qualify as a like-kind exchange, the property must be held for use in a trade or business or for investment. The following do not qualify for like-kind exchanges:
1. person use property
2. stock in trade or property held primarily for resale (inventory)
3. stocks, bonds or other notes
4. interests in a partnership
5. certificates of trust or beneficial interests
6. choses in action.

You would think that like-kind would mean that two things to be exchanges would have to be alike, such as a house for a house, but the law is much broader than that. In a real estate like-kind exchange almost any real estate parcel is like-kind to any other real estate parcel. Land can be exchanged for an apartment building and qualify as a like-kind exchange. One limitation on real estate is that United States real estate is not like-kind with foreign property.

If you exchange depreciable tangible personal property (such as autos), they must be of the same asset class (listed in IRS Publication 946).

One interesting point is that livestock of different sexes is not considered like-kind.

If you plan to engage in a like-kind exchange, you must be very careful to obey the rules. Any deviance from those rules will render your exchange a regular sale, subject to whatever tax is applicable.

You have 45 days from the day that you give up your property to identify the property you will acquire in the exchange. You must identify the replacement property in a written document, which you sign and deliver to the person obligated to transfer the replacement property. The property you are planning to acquire must be unambiguously described in this document (legal description, street address, or distinguishable name). If you are exchanging personal property, such as a truck, the document must include the make, model, and year. If the VIN is available, that should be included.

The exchange period begins on the date the relinquished property was transferred and ends the earlier of 180 days or the due date, including extension, of the income tax return year for the year the relinquished property was transferred. So, basically, you have 180s or less to finalize the sale for both your new property and the property you have given up.

Because the qualifications are so rigidly enforced, it is strongly recommended that you work with a qualified intermediary (also know as an accommodator), whose job it is to be sure that no deadlines are missed. The money spent to insure that the “deal” goes through on time is money well spent.

One type of like-kind exchange that people often fall into without even realizing they have done it is trading an auto or truck used for business. If you go to a dealer and trade-in your work truck for a new work truck, you have made a like-kind exchange, and may or may not, have tax consequences. If you sell the truck to a private buyer and then go to the dealership to purchase new truck, you will avoid possible negative complications from an unwitting like-kind exchange. If you want to trade in the vehicle, be sure to discuss the matter with your tax professional to be sure you won’t be adversely impacted.

Like-kind exchanges do not keep you from paying taxes; they only defer the tax until you sell the new property. This could benefit you if you are in a year in which you sell property and also have a greater-than-usual income.

Like-kind exchanges are very complicated, but can be very beneficial. If you are tired of the hassles in owning a rental house, you may want to exchange into an apartment building with on-sight staff or from an apartment building to a shopping center.

Before entering into one, you should consult both your tax professional and a qualified intermediary/accommodator.