Section 1031 of the Internal Revenue Code allows the owner(s) of certain property to defer federal taxes associated with gain or loss on the sale of such property by acquiring qualified similar property.
For example, a taxpayer has owned real property for 10 years. Her tax basis in the property is $300,000. If she sells the property for $1,000,000, she will be required to recognize a capital gain of $700,000, which gain will be subject to federal taxation. If, however, she acquires new, replacement property of equal or greater value in a qualifying 1031 exchange, she will be able to defer the recognition of that gain and the associated federal taxation until she sells the replacement property.
While Section 1031 exchanges, which are often called “like-kind” exchanges, are commonly associated with real property, such exchanges are not limited to real property ; rather, all but the following types of property are eligible:
“stock in trade or other property held primarily for sale, stocks, bonds, or notes, other securities or evidences of indebtedness or interest, interests in a partnership, certificates of trust or beneficial interests, or choses in action.”
26 U.S.C. § 1031(a)(2).
Property acquired in a 1031 exchange must be of “like-kind” to the relinquished property. But exactly what does “like-kind” mean? Unfortunately, the provisions of Section 1031 do not provide much guidance as to determining those properties that are “like-kind;” however, one section of the Treasury Regulations, § 1.1031(a)-1(b), which was published to aid in the interpretation of Section 1031, sets forth the following definition of “like-kind”:
“As used in section 1031(a), the words like kind have reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.”
In other words, the condition or quality of property is not of consequence when determining a property’s kind or class; rather, it is the intrinsic nature of the property that is of consequence. The same section of the Treasury Regulations later provides examples of various “like-kind” exchanges:
“No gain or loss is recognized if (1) a taxpayer exchanges property held for productive use in his trade or business, together with cash, for other property of like kind for the same use, such as a truck for a new truck or a passenger automobile for a new passenger automobile to be used for a like purpose; or (2) a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real estate, or exchanges improved real estate for unimproved real estate; or (3) a taxpayer exchanges investment property and cash for investment property of a like kind.”
In order for property to eligible for exchange treatment, the property must be either “held for productive use in a trade or business or for investment.” 26 U.S.C. § 1031(a). While this definition may seem to prohibit exchanges of property held for productive use in a trade or business for property held for investment, Treasury Regulations § 1.1031(a)-1(a) provides otherwise, in particular it provides that qualifying property held for productive use in a trade or business may be exchanged for property held for investment and, likewise, qualifying property held for investment may be exchanged for property held for productive use in a trade or business.
A qualified 1031 exchange can be either a: 1. Simultaneous Exchange, 2. Delayed Exchange, or 3. Reverse Exchange.
- Simultaneous Exchange. In terms of timing, a simultaneous exchange requires that the exchange of the relinquished property for the replacement property is, just that, simultaneous.
- Delayed Exchange. A delayed exchange requires that the replacement property must be identified within 45 days after ownership of the relinquished property is transferred and the exchange must “be completed not more than 180 days after transfer of exchanged property.” However, Treasury Regulations § 1.1031(k)-1 provides that in a deferred exchange “gain or loss may be recognized if the taxpayer actually or constructively receives money or property which does not meet the requirements of section 1031(a) before the taxpayer actually receives like-kind replacement property.”
As a result, taxpayers seeking deferred exchange treatment often employ the services of a “qualified intermediary” to hold any money or property from the sale of the relinquished property so as not to run awry of such restrictions.
- Reverse Exchange. A reverse exchange can permit exchange treatment in the event that replacement property is acquired before the sale of the relinquished property. While there are a number of additional requirements for reverse exchanges, in terms of timing Rev. Proc. 2000-37 requires that relinquished property must be identified no later than 45 days after title of the replacement property is transferred to an Exchange Accommodation Titleholder (“EAT”) and that the replacement property must be transferred to the taxpayer, a person who is not the taxpayer, or a disqualified person no later than 180 days after the transfer of the replacement property to the EAT. Further, the combined time period that the relinquished property and the replacement are held in a qualified exchange accommodation arrangement. cannot exceed 180 days.
This brief overview of some important considerations associated with 1031 exchanges is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.
Douglas Cook is an Arizona tax attorney with over 40 years of experience. Although Cook & Cook's office is located in Mesa, Arizona, the attorneys at Cook & Cook represent clients throughout the Phoenix, Arizona Metropolitan area including the following east valley cities: Scottsdale, Paradise Valley, Tempe, Chandler, & Gilbert.