THE OPPORTUNITIES AND PITFALLS OF LIKE-KIND EXCHANGES This is a very brief outline of section 1031 tax deferred exchanges, a.k.a. like-kind exchanges.  Specific advice must be obtained in each situation to ensure that the desired goals are achieved.

The principal advantage of a like-kind exchange is that the taxable gain is not recognized at the time of the exchange but, instead, that gain is deferred and added to any gain that will be taxed upon the sale of the replacement property received in the exchange.  Remember, this is a tax-deferral tool, NOT a tax elimination tool.  Taxes will ultimately be paid on the gain from the sale at some future date, usually when the replacement property is sold.  Although this sounds very simple, the federal income tax rules in this area are some of the most complex and confusing in the entire tax code and failure to comply with any requirement disqualifies the tax-deferred status of the sale.

What is like-kind?  Like-kind means that you exchange an investment asset(s) for another investment asset(s) with nearly identical characteristics.  Business equipment for business equipment.  Real estate for real estate.  But not real estate for equipment, or vice versa.  All real estate is considered like-kind, so an exchange of an apartment house for vacant land or for a commercial rental qualifies.  Multiple properties can be exchanged for a single property and a single property can be exchanged for multiple properties sold, but extreme caution must be exercised to meet the specific time limitations imposed. IMPORTANT!  A limiting factor on real estate exchanges is that it must involve investment property, NOT your personal residence.  ALSO, you cannot tax-defer exchange funds from a sale by investing in, or paying down a mortgage on an investment property you already own, and you cannot tax-defer the gain on real estate in the U.S. by exchanging it for real estate in a foreign country or vice versa.

Simultaneous or Deferred Exchange.  The exchange can take place at exactly the same time, a simultaneous exchange.  More often, the exchange is a deferred exchange.  In a deferred exchange, the replacement property MUST be “identified” within 45 days after the closing of the sale of the initial property.  In addition, the purchase of the replacement property MUST be “completed” within 180 days of the closing of the sale of the initial property, or by the extended date of the taxpayer’s tax return for the year in which the initial sale occurred, whichever date is earlier.  These times limits cannot be changed under any circumstances. 

In a deferred exchange, the seller cannot actually or constructively receive any of the proceeds or other property from the initial sale before the replacement property purchase has been completed.  The seller typically engages the services of a “qualified intermediary,” also know as an accommodator, to hold all of the sale proceeds until a replacement property is purchased. 

What actually happens is that the qualified intermediary becomes the seller of the initial property and the purchaser of the replacement property, transferring title to the replacement property to the actual buyer at the time of the closing of the purchase.

There is also a reverse exchange in which the replacement property can be acquired before the sale of the old property, but this area of the tax law is even more complex.  The qualified intermediary takes title to the new property, and then the sale of the old property is done in the intermediary's name.  The same time restraints as above apply to reverse exchanges.

How much do I need to reinvest in the replacement property?  A seller MUST invest an amount equal to ALL of the net proceeds from the sale, plus an amount equal to the balance of any liens, such as a mortgage, paid off at the time the property is sold.  So, basically, the amount invested in the replacement property must at least equal net selling price (sales price less commissions and closing costs) of the old property, which means you cannot move down in price in an exchange without triggering an income tax liability. 

There can be no cash taken out of any exchange to qualify for the full tax deferral.  Any of the sale proceeds from the old property that are not reinvested in the replacement property become fully taxable in the year of the sale.

As with all sales, the calculation of the gain is not based upon the cash changing hands.  Rather, the gain is the difference between the sellers cost basis of the property being sold, less any depreciation taken, and the sales proceeds less selling costs.

Do I need to do a 1031 tax deferred exchange on a property being sold at a loss?  No.  There is no tax advantage to an exchange involving a loss asset.

Converting a property acquired in a 1031 exchange into a personal residence.  A property acquired in a 1031 exchange can be converted into a personal residence as long as the intent of the exchange was to acquire like-kind investment property.  You cannot merely make the exchange and then turn the property into your personal residence.  At least 2 years of rental of the new property should typically occur to show the intent was to acquire an investment property.  IMPORTANT!  Once a property acquired in a like-kind exchange has been converted into a personal residence, a special rule applies to sales or exchanges of the property occurring after October 22, 2004.  The $250,000 or $500,000 normal homesale tax exclusion does NOT apply to any gain from a sale made within five (5) years of the date the property was acquired, and this rule also applies to the reduced homesale exclusion.  This means you are denied the homesale tax exclusion if you sell the exchanged property within five years from the date of purchase of the property and as a result all of the gain over the tax basis of the property will be taxable income until the five year ownership threshold is met.

Tax consideration.  The federal tax rate on capital gains from the sale of property is currently at 15%, which is the lowest capital gains rate in the last 20 years.  It can be anticipated that some time in the future this rate will increase because it is perceived as a tax benefit to the rich.  Some consideration should be given to forgoing a 1031 exchange due to the fact that a sale of the replacement property at a later date which would trigger the deferred gain may be taxed at a higher rate.

Note:  This is a very brief outline of a very complex area in our tax laws.  The rules must be followed exactly to achieve the desired benefit from the tax deferral.  Tax advice should be obtained before entering into a transaction involving an exchange so you clearly understand the tax implications of the transaction.