The term "like-kind exchange" refers to a tool that investors use to defer the payment of capital gains resulting from the disposition of an investment property. These transactions are often called 1031 exchanges, referencing the section of the Internal Revenue Code that authorizes the practice. A 1031 exchange is a proceeding by which an investor can defer the payment of capital gains due on the sale of investment property, subject to specific stipulations:
- The owner must have held the property for investment or business reasons. A primary residence or personal vacation home is typically not eligible.
- The property sold and the property purchased must be “like-kind,” which is property of the same nature or character. Most investment property is considered like-kind. For example, investors may exchange residential rental property for industrial space, or undeveloped land for retail assets.
- The transaction must adhere to strict timelines. The clock starts ticking when the investor sells the initial property. The investor has 45 days to identify potential replacement assets and 180 days from the initial sale to execute the purchases.
- The property owner must employ a Qualified Intermediary to oversee the exchange. This individual manages the process, holding funds from the initial sale in escrow (a vital point since the investor may not have access to them during the exchange period) and administering the documentation.
- The relinquished asset's fair market value and debt load must equal the fair market value and debt load of the replacement property or properties.
What about personal property?
Before Congress enacted the Tax Cuts and Jobs Act, the code section allowed exchanges of more than real estate. Business property like equipment, machinery, and vehicles was frequently eligible for exchanges. Investors could also swap assets like precious metals, coins, collectibles, artwork, jewelry, and even intellectual property. That broader definition of qualifying assets sets the foundation for a question about trade-in eligibility.
Before the TCJA narrowed the scope of what is permissible within a 1031, a trade-in vehicle or other item could have been part of the 1031 structure. However, that possibility is no longer applicable.
When are the taxes due after a 1031 exchange?
The taxes that would be due on the original sale are deferred by the completion of the 1031 exchange, subject to the satisfactory completion of the requirements. If the investor later sells the replacement property, they will then owe the taxes on the original sale plus any new capital gains taxes they owe on the latest deal. They might also owe depreciation recapture taxes.
However, investors can sequentially complete 1031 exchanges. For example, suppose you sell a residential rental and reinvest the proceeds into an office building through a 1031 exchange, thus deferring payment of the gain on the original property. Later, you decide to sell the office building and invest in a self-storage facility and some farmland. If you again execute the sales and purchases through a 1031 exchange, you may continue to defer the accumulated taxes. One strategy for an investor is to continue reinvesting through 1031 exchanges until they distribute the assets to their heirs, who would benefit from the step-up basis when they receive the bequest.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
