Home » Taxes » Tax Reform And The Change To Irs Code Section 1031 Like

Tax Reform And The Change To Irs Code Section 1031 Like

October 11, 2023
Bill Kimball

Larry identifies an apartment building held by Mary in Chicago, with a FMV of $1,000,000. Larry can exchange his ranch for the Chicago apartment building and under the like-kind exchange rules defer the recognition of the $800,000 gain (1,000, ,000). Larry’s basis in the Chicago apartment building will be equal to his $200,000 basis in the ranch. Therefore, if Larry sells the apartment building in the future the gain that was deferred will be recognized.

An exchange can only be made with like-kind properties and IRS rules limit use with vacation properties. There are also tax implications and time frames that may be problematic. If you’re considering a 1031—or are just curious—here is what you should know about the rules.

  • An exchange utilizing 1031 is known as a deferred or delayed exchange.
  • The definition of “real property” determines whether gain is deferred versus taxable in a Sec. 1031 exchange.
  • However, the basis of the property received by the taxpayer in a like-kind exchange with a relative is governed by section 1031.
  • One of the main ways people get into trouble with these transactions is failing to consider loans.
  • With respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.
  • He pays capital gains tax on the $300,000 gain and defers tax on the remaining $200,000 gain ($500,000 taxable gain minus $300,000) until he sells the new asset.

Therefore, although there may be gain recognition based on the incidental acquisition of personal property, a portion of the replacement property is allocated to the personal property. Thus, the gain can be reduced by taking accelerated depreciation on the personal property. 1031 Like-Kind Exchanges have been a part of real estate for one hundred years. A way to trade properties instead of going through the traditional buying and selling process, like-kind exchanges also often result in the ability to bypass capital gains taxes. These transactions are complicated and have many special rules. As you can imagine, completing a like-kind exchange is not a simple undertaking as it can take a considerable amount of time to both identify like-kind property and to complete the transaction. In addition, a direct exchange is not always practical because the two parties involved might not have property the exchanging party is interested in.

However, the many complex moving parts not only require understanding the rules but also enlisting professional help—even for seasoned investors. Now, if you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange. In other words, you’ll have to wait a lot longer to use the primary-residence capital-gains tax break. The TCJA includes a transition rule that permitted a 1031 exchange of qualified personal property in 2018 if the original property was sold or the replacement property was acquired by December 31, 2017. The 1031 provision is for investment and business property, although the rules can apply to a former primary residence under certain conditions. There are also ways you can use 1031 for swapping vacation homes—more on that later—but this loophole is much narrower than it used to be.

Tax Reform And The Change To Irs Code Section 1031 Like

Due to the change under the TCJA and the limitation of like-kind exchanges only to real property, some questions were raised. In response, the proposed regulations provide clarification needed on the definition of “real property.” In addition, they provide guidance on the impact of incidental personal property tied in with the real property like-kind exchange. While the proposed regulations had not been finalized as of August, taxpayers can rely on them for exchanges of real property beginning after Dec. 31, 2017, if followed consistently and in their entirety. President Biden is not the first administration to attempt to limit 1031 exchanges. The Tax Cut and Jobs Act passed in December of 2017 under the Trump administration significantly altered 1031 exchanges by excluding personal certain personal property and intangible property in the deferral calculation. President Biden’s proposal would still allow for 1031 exchanges of real property, but minimize the benefit to only allow a deferral of $500,000 per year or $1 million if filing a married filing joint return.

Like-Kind Exchange

Taxpayer A owns a 10-unit multifamily property worth $1.5 million. His tax basis, or current investment interest, in the property is $1 million, leaving a $500,000 taxable gain if he were to sell it. The owner wants to sell this property to purchase a $1.2 million, 10-unit apartment building.

Get Your Clients Ready For Tax Season

One way tax laws support investment in real estate is through Section 1031 like-kind exchanges. If the properties are not equal in value, some cash or other property is tossed into the deal. This cash or other property is known as “boot.” If boot is involved, you may have to recognize your gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you get in the like-kind property you receive is equal to the basis you had in the property you gave up, reduced by the amount of boot you received but increased by the amount of gain recognized. Finally, the qualified intermediary, as required under IRS Code 1031, must transfer the replacement property to the Seller within 180 days of the relinquished property transfer.

Is 1031 going away?

Members of the House Ways and Means committee sent out letters recently to their constituents letting them know that Section 1031 of the Tax Code was safe. While the bill has yet to be finalized and voted on, we can be assured that the Tax Deferred Exchange is safe, for now at least.

For example, an exchange of commercial real estate for a ranch or farm is considered an exchange of like-kind property. Due to the broad definition of like-kind real estate, real estate professionals have utilized this provision to diversify their holdings and defer taxable gain on the disposition of property. Under the Tax Cuts and Jobs Act, Section 1031 now applies only to exchanges of real property and not to exchanges of personal or intangible property.

An exchange of real property held primarily for sale still does not qualify as a like-kind exchange. A transition rule in the new law provides that Section 1031 applies to a qualifying exchange of personal or intangible property if the taxpayer disposed of the exchanged property on or before December 31, 2017, or received replacement property on or before that date. However, in this situation, taxpayers may be able to take 100% additional first-year depreciation, known as “bonus depreciation,” on the personal property. Under the TCJA, bonus depreciation increased to 100% from 50% for qualifying property acquired with a recovery period of 20 years or less and placed in service after Sept. 27, 2017, and before Jan. 1, 2023.

How To Use Real Estate To Put Off Tax Bills

In some ways, this practice is akin to what we now call “crowdfunding” and is available for both residential and commercial real estate. Once you invest, you are a partial owner of both the equity and the debt.

  • Moreover, the coalition continues to have meetings with Members of Congress to explain the importance of tax-deferred exchanges in their states and districts.
  • Assume that taxpayer sells its $100,000 lot, but has an interest in reinvesting and therefore structures a deferred exchange by hiring a QI before closing.
  • However, in this situation, taxpayers may be able to take 100% additional first-year depreciation, known as “bonus depreciation,” on the personal property.
  • Non-recognition is conferred on a like-kind exchange on the basis that the form of the taxpayer’s investment changes while the substance of the investment does not.
  • Select to receive all alerts or just ones for the topic that interest you most.

With a like-kind exchange, he can exchange the assets and defer some of those gains. In this transaction, he exchanges his property for the new one and receives $300,000 from the seller. He pays capital gains tax on the $300,000 gain and defers tax on the remaining $200,000 gain ($500,000 taxable gain minus $300,000) until he sells the new asset. A Section 1031 exchange allows him to continue investing in job-creating real estate instead of being forced to hold properties solely for tax considerations. 1031 Like-Kind exchanges, often used to “trade” one real estate property to defer capital gains taxes, have many rules. With many moving parts, there are special rules for depreciable properties, a 45-day rule, a 180-day rule, a reverse exchange and various other rules for second properties, vacation homes etc.

For example, an apartment building would generally be like-kind to another apartment building. However, real property in the United States is not like-kind to real property outside the United States. Assuming that Sue receives no other property (i.e. boot), she defers her $3500 California source gain. Under California law, Sue must annually report deferred California source gains on FTB 3840. Delaware Statutory Trusts, which were created over 30 years ago, are way to take part in a 1031 Exchange without being the sole owner of a property.

New property receives the basis of the old property, adjusted in value for any other property given or received in the exchange (see below for further discussion of “boot”). The property or asset being sold (“old property”) must be held for investment or use in a trade or business, and cannot be a personal residence.

The assignment allows the qualified intermediary to use the money from the relinquished property to purchase the replacement property. In order to proceed with a delayed exchange, the Seller must market the property, secure a Buyer, and execute a sales agreement for the property.

Calculate Your Gain Examples

Assuming Larry in our above example is single, under the Biden proposal, only $500,000 of the gain could be deferred and Larry would have to report $300,000 of capital gain on his tax return. Exchange that includes incidental personal property constituting up to 15% of the aggregate fair market value. For example, a taxpayer may identify a hotel it will acquire for $1,000,000 as replacement property, even if the purchase involves $850,000 of real property and $150,000 of furniture and fixtures incidental to the real property. This rule only applies to the identification of the replacement property; thus, the taxpayer in this example is still acquiring $850,000 of real property for purposes of the exchange and separately purchasing $150,000 of personal property. The proposed regulations gave the example of a gas line running into a building.

What is the most common type of 1031 exchange?

The delayed exchange is the most common form of 1031 exchanges. A delayed 1031 exchange occurs when the business or investor relinquishes the initial property before identifying and acquiring the replacement property.

To qualify, most exchanges must merely be of “like-kind”—an enigmatic phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. Ensuring the nation has sufficient housing is an important public policy goal, and one that is pursued through housing and tax policy.

Real property located in the United States and real property located outside the United States are not property of a like kind. This section shall not apply to any exchange which is part of a transaction structured to avoid the purposes of this subsection. For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267 or 707. The 1031 exception is based upon the “continuity of investment” principle. When a taxpayer partially or completely “cashes out” of the investment, tax is owed on the taxpayer’s gain. Normally, when that property is eventually sold, the IRS will want to recapture some of those deductions and factor them into the total taxable income.

Personal Property Exception

As of 2013, expansion and exploitation by major corporations of like-kind exchanges, originally intended to relieve family farmers of capital gains tax when swapping land or livestock, to avoid taxes was cited by The New York Times as an example of the need for tax reform. The taxpayer’s basis in the new property is determined by starting with the taxpayer’s basis in the old property exchanged. Adjustments are then made as needed to account for other property that may be received in the exchange.

If he were to sell the first building and buy the second, he would have to pay tax on the $500,000 gain, which might discourage him from pursuing the transaction. The definition of “real property” determines whether gain is deferred versus taxable in a Sec. 1031 exchange. Under the proposed regulations, real property includes land and land improvements, unsevered crops and other natural products of land, and water and air space superjacent to land. The definition of real property includes an inherently permanent structure (i.e., buildings, roads, and bridges) or a structural component of an inherently permanent structure (i.e., walls, doors, and wiring). The proposed regulations provide a list of structures that qualify as real property as well as factors that must be used to determine if the property is considered an inherently permanent structure.

You must rent the dwelling unit to another person for a fair rental for 14 days or more. If used correctly, there is no limit on how frequently you can do 1031 exchanges.

While this may seem like a large amount to many, such a limit would greatly diminish the use of section 1031 and seriously damage the real estate sector of the economy. Like-kind exchanges can provide REALTORS® with the opportunity to work with two properties, and NAR finds it an essential part of the real estate sector. They promote investment, job growth, and can greatly benefit underserved markets. The IRS has many rules regulating like-kind exchanges, which affect taxes sometimes drastically. You can view the various forms and directions on the IRS website. If it’s a straight real estate exchange , you will not have to recognize any gain from the exchange.

Through use of the QI, the taxpayer never actually or constructively receives any proceeds from the sale of the relinquished property. Thus, it is deemed an “exchange,” i.e., a trade of property for property, as opposed to a sale and subsequent purchase, i.e., a disposition of property for cash, followed by an acquisition of new property for that same cash. Congress responded to this ruling by imposing time limits on the identification and receipt of replacement property. A 1031 exchange can be used by savvy real estate investors as a tax-deferred strategy to build wealth.

If paragraph applies to any property for any period, the running of the period set forth in subsection with respect to such property shall be suspended during such period. States that the words “like kind” refer to the nature or character of property, and courts generally hold that to mean virtually any real property is of like kind to virtually any other real property, regardless of whether improved or unimproved. In sum, the TCJA made the key inquiry in most cases the examination of what constitutes real property. The proceeds from the sale must be used to purchase the new property within 180 days of the sale of old property, although the new property must be identified within 45 days of the sale. It’s important to complete the form correctly and without error. If the IRS believes you haven’t played by the rules, you could be hit with a big tax bill and penalties. You must notify the IRS of the 1031 exchange by compiling and submitting form 8824 with your tax return in the year that the exchange occurred.

A 1031 can help to delay that event by essentially rolling over the cost basis from the old property to the new one replacing it. In other words, your depreciation calculations continue as if you still own the old property. Tax liabilities end with death, so if you die without selling the property obtained through a 1031 exchange, your heirs won’t be expected to pay the tax you postponed paying. They’ll inherit the property at its stepped-up market-rate value, too.

Deferring capital gains and depreciation recapture taxes effectively leaves her with extra money to invest in the new property. The Trump tax reform repealed personal property exchanges, commonly referred to as “like-kind” exchanges or “Starker” exchanges . A like-kind exchange is an exchange of property held for investment or for productive use in your trade or business for like-kind investment property or trade or business property. © 2021 Bloomberg Finance LP Like-kind exchanges, also referred to as 1031 exchanges, have been in the tax code since 1921 and have allowed for taxpayers to exchange property that is similar and defer the recognition of gain. The justification surrounding the deferral of gain is that a taxpayer who enters into the exchange is merely changing their investment vehicle. Based on the mechanics of the provision, the taxpayer’s gain that would have been recognized had they sold the property outright is embedded in the property received.