Like-Kind Exchanges under IRC §1031
a four part series
Like-Kind Exchanges under IRC §1031 allow taxpayers to defer, and sometimes even avoid, capital gains taxes if they quickly replace the investment or business asset that they are selling with similar property of equal value. In this post we will explain some of the pros and cons of 1031 exchanges.
- Tax deferral. The sale of a business or investment property could result in high capital gains taxes – taxes which can be deferred indefinitely if you reinvest in a replacement property within the prescribed time limits.
- Leverage and increased cash flow for reinvestment. With access to the entire proceeds of the sale, including the extra cash that would otherwise be used to pay capital gains taxes, an investor or business can make down payments on more properties.
- You can join a TIC. Participation as a Tenant-in-Common (TIC) allows an investor to diversify their holdings by owning a fractional interest in multiple properties along with up to 35 other investors, and still qualify for 1031 treatment when properties are exchanged.
- Opportunity to accumulate significant wealth over time. Investors who perform 1031 exchanges continually for many years may gradually build a significant portfolio and benefit from increased cash flow from numerous investment properties. They can eventually pass these properties on to their children, who may receive a step-up in basis at their death - resulting in no capital gains taxes through to the next generation.
- “Tax deferred” does not mean “tax free”. Unless an investor is planning on a lifetime of continuous investment with all exchanged property to eventually be passed on to their children, capital gains taxes will eventually come due. 1031 exchanges offer only tax deferral, not forgiveness of a tax debt. Also note that tax laws tend to change over time, as do tax rates - and they may increase!
- Reduced basis in the new property. The replacement property will receive the basis of the relinquished property. If the exchange was made between depreciated properties, the same depreciation method and rate will be continued for the replacement property. If the exchanged property is subject to depreciation recapture, the depreciation that was previously claimed will be recaptured as ordinary income.
- Losses are not recognized. Like-kind exchanges are not at all useful in the event of a loss, because losses under 1031, like gains, are not recognized regardless of the amount of boot received. The investor or business will have to carry the loss forward as a higher basis in the property received.
- Many inflexible rules and regulations to follow. Here are just a few: You need to identify a replacement property within 45 days and close on the new property within 180 days. You can’t touch the proceeds. You can’t flip a property or you risk the IRS claiming that you bought it for the purpose of resale and not investment – in that case the IRS will assess taxes for ordinary income, not capital gain. Unless you rent them out and meet other requirements, you generally can’t do a 1031 exchange on a residence or vacation home. Related parties (family members and others sharing ownership or control) must hold an exchanged property for at least two years to qualify for tax deferral.
Protecting your investment
Investors should do their research before choosing a Qualified Intermediary and make sure that their assets are protected – and available for another purchase within the 180 day time frame - in the event the intermediary absconds with the cash, or is sued and has its accounts frozen.
A Law Firm for all your tax needs
The tax law professionals at Moskowitz LLP provide the firm’s clients with advice on all aspects of tax law, including how individuals and businesses can legally minimize federal and state tax liability. If you are planning a 1031 exchange or are in need of assistance with a tax litigation matter involving a 1031 like-kind exchange, we can help.
Our final post in this series will focus on common audit issues that arise in the context of 1031 exchanges.