Most business owners have heard of a like-kind exchange, or a 1031 exchange using tax parlance. A 1031 exchange is a very formal process which is codified through the Internal Revenue Code in IRC 1031 and the underlying regulations. A 1031 exchange allows a business owner, or an investor, to defer capital gains on the sale of real estate.
The 1031 exchange is a common tax planning opportunity, but understanding the requirements is vital to obtaining the expected tax result.
Here are the rules surrounding a 1031 exchange:
- The exchange must be comprised of real property that is used in a trade or business, or for investment purposes;
- The replacement property must be of like-kind to the relinquished property in the exchange;
- Stringent time periods must be adhered to, including 45 days to identify replacement property and 180 days to complete the entire exchange;
- A qualified intermediary (QI) must be used for the sale of the relinquished property. A QI is an independent person, company, or entity that enters into a written agreement with the exchanger to facilitate the transfer of proceeds.
The first rule is specific to real property. Prior to the Tax Cuts and Jobs Acts (TCJA), Section 1031 applied to like-kind exchanges of any property type (both personal and real) held for productive use in a trade or business or for investment if said property was exchanged solely for property of like-kind to be held for productive use in a trade or business or for investment purposes. That is no longer the case, as post-TCJA, like-kind exchanges now apply only to exchanges of real property.
The second rule focuses on the type of property. The replacement property and relinquished property must be “like-kind” which is very generally interpreted and means that both must be held either for use in a trade or business or for investment, but the properties do not have to be similar in service or related in use. A condominium can be exchanged for a single-family dwelling or a shopping center for an office building. Any investment or business property can be exchanged for any other investment property or business property.
The last rule formalizes the timing requirements to complete a successful 1031 exchange. The 1031 exchange regulations require that within 45 days of closing a sale of the relinquished property, the taxpayer must identify replacement property. This is usually done by letter to the QI. Within 180 days of closing a sale of relinquished property, or before the taxpayer’s next tax return is due, the taxpayer must acquire the replacement property.
The above timing requirements are generally absolute and are unable to be changed. However, we have seen instances in which a situation out of the taxpayer’s control has extended the period. Most recently, we have seen the COVID-19 pandemic as well as other federally declared disasters create additional time necessary to complete exchanges. The IRS will release guidance as to whether a disaster within an impacted area creates an opportunity to extend the time periods. This guidance and release is available here on the IRS website under the Tax Relief in Disaster Situations.
A 1031 exchange provides both business owners and investors an excellent tax planning opportunity. If the sale of real estate is expected in the near-term, it’s a good idea to evaluate whether a 1031 exchange makes sense from a business and investment standpoint.