Like-kind exchanges, or Section 1031 exchanges, have changed for 2018.
There used to be a time when you could exchange one income-producing property (including the assets of a business) for another. However, under the Tax and Job Cuts Act (TCJA), a 1031 can only be done with real estate.
It is important to point out a 1031 is not an avoidance of tax. It is simply a deferment to another tax year. Here are the ins and outs.
The textbook example of a 1031 is two people sit at a closing table and exchange titles of properties. However, this is rarely the case in practice.
Instead, the first property is usually sold first. The proceeds of the sale are held onto by a qualified intermediary.
It’s important to point out that a qualified intermediary can be anyone except your lawyer or accountant. That being said, it is not a regulated industry, so if your client asks for a referral, do your homework.
Within 45 days, the taxpayer has to identify up to three properties to the qualified intermediary. Now, it’s important these properties are like-kind. For example, you can’t exchange a rental property for raw land.
After the properties are identified, the taxpayer has 180 days or until the due date of the tax return, including extensions, to take possession of them. These deadlines are hard and fast, and if they are missed, the sale of the first property is taxable.
To be non-taxable at the time of the exchange, the taxpayer cannot constructively receive the money. If this happens, the exchange is null and void.
The taxpayer may also exchange the proceeds into more than one property. However, if a mortgage is taken out or any more money is added to the exchange, that can be considered taxable “boot.”
Let's look at an example. A taxpayer uses personal funds to pay for the deposit on the replacement property contract in the amount of $20,000. At the termination of the exchange, following the receipt by the taxpayer of all like-kind property they were entitled to, the qualified intermediary returns the excess cash remaining in the exchange escrow account in the amount of $10,000. The net taxable cash boot received by the taxpayer is $10,000, the difference between the cash boot received and the cash boot paid.
Net mortgage boot is received by the taxpayer if the mortgages paid off at the time of the sale of the relinquished property are greater than the new mortgages taken on in the acquisition of the replacement property. Notwithstanding, if the taxpayer is in receipt of a net mortgage boot, what is received may not be taxable if it is offset by the net cash boot given.
For example, if the mortgages paid off at the time of sale of the relinquished property exceed the new ones taken on at the acquisition of the replacement property by $10,000, there is a net mortgage boot received in the amount of $10,000. If the taxpayer has paid net cash boot in that amount or greater, then the cash boot given offsets the mortgage boot received, and there is no taxable boot. If the taxpayer paid a $7,000 net cash boot, then the $7,000 net cash given offsets the same amount of the mortgage boot received, leaving $3,000 net taxable boot received.
As I mentioned before, a 1031 is just a deferral of tax. There is nothing formal that says this, but there are several Tax Court cases that point to the fact the the exchanged property should be held by the taxpayer for at least two tax returns. Certainly, they can exchange the replacement property again after the two years, but they should know they are just kicking the can down the road to another tax year when the property is sold.
I had a client who did a 1031. Two years later, he did another one, and then another. He did about four or five of them until he found his dream house. He rented this property out for two years and then converted it to personal use.
The affect was there will be no taxable event, because by the time he sells the property, it would be considered his personal residence.
Overall, 1031 exchanges are complicated. You should take the time to know all of the ins and outs before suggesting them to a client.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...