1031 Like-Kind Exchanges offer businesses and investors the opportunity to maximize their return on real estate investments while minimizing their capital gains tax bill.
- Allowable under Internal Revenue Code 1031, Like-Kind Exchanges are used to defer the payment of capital gains taxes on the sale of real property.
- The basis of the relinquished property is transferred to the replacement property, thereby delaying the payment of the capital gains tax.
- While the tax benefits of 1031 Like-Kind Exchanges are obvious, businesses and investors need to be aware of the intricacies involved in such transactions.
Keeping the Like-Kind Exchange file handy could pay off handsomely for businesses and investors. Allowable under Internal Revenue Code 1031, Like-Kind Exchanges are used to defer the payment of capital gains taxes on the sale of real property. With a Like-Kind Exchange, the basis of the relinquished property is transferred to the replacement property, thereby delaying the payment of the capital gains tax.
Businesses and investors can use the tax law to maximize their return on real estate investments. In theory, businesses and investors could use Like-Kind Exchanges to continually benefit from investments without ever having to pay capital gains taxes.
The challenge for finance and real estate executives? Making sure that Like-Kind Exchanges are considered—and used—whenever possible. As such, it’s important for corporate executives and investors to keep Like-Kind Exchanges in mind when managing all types of real estate investments. The rule can be implemented in many situations, not just those that are most obvious.
Uses of Like-Kind Exchanges
A Like-Kind Exchange could work well when a shortage of cash might be preventing the company or investor from seizing a promising real estate investment. While a company or investor might typically sell existing real estate to raise the funds necessary to purchase new real estate, the gains realized on the sales are subject to high federal and state taxes. Such penalties are enough to make the executives and investors forget about investing in the new property. By completing a Like-Kind Exchange, however, the business could use the entire proceeds on the sale of the property to purchase a new property without paying a single dollar in capital gains taxes.
Alternatively, executives and investors should consider using a Like-Kind Exchange when selling a piece of real estate because they no longer use or need the property—even if they have not yet purchased, or even identified, a replacement property. They can take up to 45 days after the sale of the relinquished property to identify potential replacement properties, and up to 180 days after the sale to acquire the identified property or properties.
Understand of the intricacies of Like-Kind Exchanges
While the tax benefits of Like-Kind Exchanges are obvious, businesses and investors need to be aware of the intricacies involved in such transactions.
First, to take advantage of this tax provision, the properties being bought and sold need to be of a “like-kind.” That is, real property (real estate) must be exchanged for real property. The property being exchanged, however, does not have to be exactly the same type or use, or of an equal value. For instance, in Like-Kind Exchanges, a large rental house could be relinquished while apartment building or office building is purchased. However, prudence dictates that the new property be of equal or great value than the relinquished property, and that all of the equity be reinvested in the acquisition.
Under the law, the complete transaction must take place within a certain period, but it does not have to be a simultaneous swap. The estate property could be sold at the beginning of the period—and then the replacement property purchased at the end of the 180-day acquisition period. However, a list of 1031 qualified exchange properties must be identified within 45 days after the relinquished property is sold.
A related Revenue Procedure even allows investors to purchase the new property before the relinquished property is sold. With these reverse Like-Kind Exchanges, the entire transaction must still take place within the 180-day exchange period.
To successfully complete a Like-Kind Exchange, the taxpayer must avoid even “constructive receipt” of the exchange proceeds. Typically, the services of a “qualified intermediary” are engaged to hold the money from the first settlement. A qualified intermediary is a person who enters into a written agreement with the taxpayer to acquire relinquished property from the taxpayer, transfer that property to the purchaser, acquire replacement property, and then transfer the replacement property to the taxpayer. The exchange may be completed without the cooperation of the purchaser of the property. The taxpayer’s relatives, accountant, broker, or attorney are among a list of disqualified parties who cannot serve as the taxpayer’s qualified intermediary.
Armed with an understanding of 1031 Like-Kind Exchanges and a working knowledge of how to execute such exchanges, businesses and investors can maximize their return on investments while minimizing their capital gains tax bill.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
IRC Section 1031 allows taxpayers to defer the gain on the disposition of business or investment real estate, if that real estate is replaced with like-kind real estate, within specific timeframes. Consult your tax or legal advisor for additional information on the requirements and limitations of such exchanges. Wilmington Trust 1031 Exchange LLC is a wholly owned subsidiary of Wilmington Trust, N.A. Wilmington Trust 1031 Exchange LLC does not provide tax or legal advice to clients.