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Liking “Like Kind” Exchanges
Published Date : October 14, 2014
Like other sections of the tax code, the 1031 Exchange is increasingly familiar, if not always well-understood, and it can be useful in the right situation. Section 1031 describes the circumstances where exchanges of “like-kind” properties are permitted that can defer recognition of both capital gain and taxes. Strict limitations and guidelines apply, and thus professional tax advice should be involved. The 1031 exchange lets property held for productive use in trade or business to be swapped for another “like-kind” property without recognizing a gain in the process, allowing the new investment to continue to grow tax- deferred. Stocks and bonds and most partnership interests do not qualify, though interests in tenant-in-common ownership of real estate do. Indeed, most 1031 exchanges involve real estate of some kind; but some types of personal property, such as artwork, can also qualify.
Section 1031 only covers investment property and not one’s primary residence, which has its own attractive and unique tax features. Using vacation homes for such exchanges is possible, but problematic; the rules have tightened up significantly in recent years and require careful review. A more typical exchange might be an apartment building—perhaps where the owner has been willing to actively manage the property and create some “sweat equity” in addition to normal rental income.
The definition of “like kind” is quite broad—for example, an apartment can be exchanged for raw land, or a vineyard for an office park. However, care should be taken with certain exchanged properties where depreciation has occurred, which can be recaptured and result in taxable income. Also, any net cash—known as “boot”— that is left over after the swap is settled, will create partial sales proceeds that are taxable, and any reduction in debt or mortgages will also usually be recognized as taxable income.
Despite the inherent attractiveness of many exchange opportunities, rarely will an investor be able to simultaneously identify and instantly swap one property for another. For this reason, most 1031 exchanges are delayed transactions that involve third party intermediaries, also known as Starker exchanges for the tax case that allowed them. In order to succeed, investors cannot take receipt of any sales proceeds—hence the intermediary. Strict rules govern the timing of such delayed exchanges, with no forgiveness by the IRS for missing prescribed dates.
There are many valid situations and good reasons for using 1031 exchanges, but there are also many other factors to consider in the overall analysis, including: transaction costs, property/income taxes, insurance, maintenance, repair, improvements, vacancies, and other hidden expenses… plus the basic “hassle factor” of dealing with the property and no guarantee of capital appreciation (on top of any expected income stream). Also, if now might be deemed a good time to sell (and exchange) a particular property—especially after the strong recent run in real estate values—then by definition this might not be the ideal time to buy a “replacement” property.
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