Tax Reform and the Change to IRS Code Section 1031 Like-Kind Exchanges (Starker Exchanges)
The passing of the Tax Cuts and Jobs Act ushered in a number of changes in our tax law. One significant tax repeal is under Internal Revenue Code Section 1031, which permits the deferral of capital gains tax.
The Trump tax reform repealed personal property exchanges, commonly referred to as “like-kind” exchanges or “Starker” exchanges (based upon the first tax court case that permitted these transactions). 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.
Under the repealed Section 1031, exchanges now apply exclusively to real estate assets.
Examples of personal property assets that can no longer be exchanged include: intangibles, franchise licenses and patents, aircraft, vehicles, machinery and equipment, boats, livestock, artwork and collectibles. There are transition rules, however, that permit a personal property exchange to be completed in 2018 if either the relinquished property was sold or the replacement property was acquired by the taxpayer during 2017.
Types of Real Estate Exchanges
There are three common types of Real Estate Exchanges under IRS Code 1031: Simultaneous Exchange, Delayed Exchange, and Reverse Exchange.
A Simultaneous Exchange occurs when the replacement property and relinquished property close on the same day. It is important to note that the exchange must occur simultaneously. Any delay -- even a short delay caused by wiring money to an escrow company -- can result in the disqualification of the exchange and the immediate application of full taxes.
There are three basic ways that a simultaneous exchange can occur:
- Swap or complete a two-party trade where the two parties exchange or “swap” deeds.
- Three-party exchange where an “accommodating party” is used to facilitate the transaction in a simultaneous fashion for the Seller.
- Simultaneous exchange with a qualified intermediary who structures the entire exchange.
A Delayed Exchange is when the party selling the property (the “Seller”) relinquishes property (the “relinquished property”) before they replace property (“replacement property”). In other words, the relinquished property is sold first, and the replacement property is purchased second.
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. The Seller’s obligation to sell the relinquished property is then assigned to a qualified intermediary. By assignment, the qualified intermediary transfers the relinquished property to the Buyer in exchange for payment of the purchase price from the Buyer.
Within 45 days after the transfer of the relinquished property by the qualified intermediary to the Buyer, the Seller must identify replacement property to purchase. The Seller negotiates the purchase terms for the replacement property and executes a purchase and sale agreement. The Seller’s obligation to buy the replacement property is then assigned to the qualified intermediary. The assignment allows the qualified intermediary to use the money from the relinquished property to purchase the replacement property.
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.
A Reverse Exchange, also known as a Forward Exchange, occurs when you acquire a replacement property through an exchange accommodation titleholder before you identify the replacement property. In theory, this type of exchange is very simple: you buy first and you pay later.
What makes reverse exchanges tricky is that they require all cash. Additionally, many banks won’t offer loans for reverse exchanges. Taxpayers must decide which of their investment properties are going to be acquired and which will be “parked.” A failure to close on the relinquished property during the established 180 day period that the acquired property is “parked” will result in a forfeit of the exchange and tax implications.
The reverse exchange follows many of the same rules as the delayed exchange. However, there are a few key differences to note:
- In a reverse exchange, Taxpayers have 45 days to identify what property is going to be sold as “the relinquished property.”
- After the initial 45 days, Taxpayers have 135 days to complete the sale of the identified property and close out the reverse 1031 exchange with the purchase of the replacement property.
Final Thoughts: Tax Rules for Real Estate Exchanges Under IRS Code Section 1031
Assuming the transaction qualifies as one of the above types of exchanges, here's how the tax rules work:
If it's a straight real estate exchange (meaning properties are equal in value), you will not have to recognize any gain from the exchange. You will take the same “basis” (your cost for tax purposes) in your new property that you had in the old property. Even if you do not have to recognize any gain on the exchange, you still have to report the exchange to the IRS.
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.
If the relinquished property is subject to debt from which is being relieved, the amount of the debt is treated as boot. The theory is that if someone takes over your debt, it's equivalent to his giving you cash. Of course, if the replacement property is also subject to debt, then the Seller is only treated as receiving boot to the extent of the “net debt relief” (the amount by which the debt becomes free or exceeds the debt on the replacement property).