The ability to defer taxes on exchanges of like-kind property dates back to the Revenue Act of 1921, P.L. 67-98. Sec. 1031, the current statutory authority relating to like-kind exchanges of property, was initially designed to promote economic growth and investment by allowing taxpayers to defer taxes when exchanging property of a like kind. Sec. 1031 has been modified many times over the years, most recently by the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, which limited to real property the type of property eligible for like-kind exchange treatment.

Updated regulations primarily focused on the definition of real property were published in December 2020. The remainder of the like-kind exchange rules remain intact after enactment of the TCJA. This item discusses the basic requirements for like-kind exchange treatment, explains updates to the definition of real property, and highlights issues that taxpayers should keep in mind when engaging in these transactions.

Background

Sec. 1031(a)(1) provides that, in general: no gain

or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.

In the case of like-kind exchanges, property transferred by the taxpayer is referred to as “relinquished property,” and the property received by the taxpayer is referred to as “replacement property.”

Prior to the TCJA, virtually any property held for investment or for use in a trade or business other than certain specified property types (including stocks, bonds, notes, and partnership interests) was eligible for like-kind exchange treatment. The TCJA limited the type of property eligible for like-kind exchange treatment to real property. Therefore, after the TCJA’s enactment, personal property, such as vehicles, equipment, and artwork, is no longer eligible for tax-deferred treatment under Sec. 1031.

Real property

Given that the TCJA limits like-kind exchanges to real property, it is necessary to understand what constitutes real property for this purpose. Property that is real property under state or local laws is considered real property for the like-kind exchange rules pursuant to Regs. Sec. 1.1031(a)-3(a)(1). For purposes of this test, the property must be classified as real property under the law of the state or local jurisdiction in which that property is located as of the date it is transferred in an exchange (see Regs. Sec. 1.1031(a)-3(a)(6)).

The following types of property will qualify as real property under Sec. 1031 even if they are not classified as real property by state or local law: (1) land and improvements to land; (2) unsevered natural products of land; (3) water and airspace superjacent to land; and (4) an intangible interest in such real property, including fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, or a similar interest in real property (Regs. Sec. 1.1031(a)-3(a)).

Regs. Sec. 1.1031(a)-3(a)(2) provides that “the term improvements to land means inherently permanent structures and the structural components of inherently permanent structures.” Under Regs. Sec. 1.1031(a)-3(a)(2)(ii)(A), an inherently permanent structure is “any building or other structure that is a distinct asset and is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time. Affixation is considered permanent if it is reasonably expected to last indefinitely based on all the facts and circumstances.”

Under Regs. Sec. 1.1031(a)-3(a)(2) (ii) (B), “a building is any structure enclosing a space within its walls, and covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space.”

The regulations specify certain inherently permanent structures. Regs. Sec. 1. 1031(a)-3(a)(2)(ii)(C) provides that property of a type not specifically enumerated can also qualify as an inherently permanent structure if it can be treated as permanently affixed to the real property based on the following factors:

• The manner in which it is affixed to the real property;
• Whether it is designed to be moved;
• The damage that removing it would cause either to the asset or to the real property;
• Any circumstances that suggest that it is not expected that the asset will be affixed indefinitely; and
• The time and expense to move the asset.

Deferred exchanges

A deferred exchange is any exchange other than a simultaneous exchange of one property for another like-kind property. When engaging in a deferred exchange, the taxpayer uses a qualified intermediary (QI) or other approved method, such as a qualified escrow account or qualified trust, to avoid actual or constructive receipt of proceeds from disposition of the relinquished property, which would cause immediate recognition of gain or loss.

A QI is defined as a person who is neither the taxpayer nor a disqualified person and who enters into a written exchange agreement with the taxpayer pursuant to which the QI acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer (Regs. Sec. 1.1031(k)-1(g)

(4) (iii)). As with qualified escrow accounts and qualified trusts, the insulation from actual or constructive receipt offered by a QI terminates at the time the taxpayer has the immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the QI (Regs. Sec. 1.1031(k)-1(g)(4)(vi)).

Although not mandated by the regulations in connection with their role as a QI, a QI typically assists the taxpayer with ensuring that the following requirements are met:

1. Within 45 days of the date the taxpayer transfers the relinquished property, the replacement property is properly identified in a written document signed by the taxpayer and sent to either the person obligated to transfer the replacement property to the taxpayer, or any other person involved in the exchange other than the taxpayer or a disqualified person.

2. The replacement property is received by the earlier of:

a. The due date for the filing of its tax return (including extensions) for the tax year of the exchange, or

b. 180 days after the date the taxpayer transfers the relinquished property, provided the property is received and it is substantially the same property as the replacement property that was identified.

3. The value of the replacement property is at least equal to the value of the relinquished property.

Held for productive use in a trade or business or investment

One common foot fault is where either the relinquished property or the replacement property is not held for productive use in a trade or business or for investment. This might occur if the taxpayer sells or acquires a property used as a vacation home. Although a vacation home meets the definition of real property, it may not qualify as being held for investment or use in a trade or business.

The Tax Court held that an exchange of residences that were never rented and that were used primarily for vacation purposes did not qualify as a like-kind exchange despite the owner’s “investment” hope that the homes would be sold at a gain (see Moore, T. C. Memo. 2007-134). However, an individual’s occasional personal use of a dwelling that the taxpayer rents out will not preclude qualification of the dwelling as property held for productive use in a trade or business or for investment if the safe harbor under Rev. Proc. 2008-16 is satisfied. Under the safe harbor, minimum periods of ownership and rental of the relinquished and replacement property must be met, and personal use cannot exceed certain thresholds.

Receipt of other property and money

Even if all tests are met for an exchange to qualify under Sec. 1031, gain or loss will be recognized to the extent nonqualifying property or money is received. Assumption of debt is treated as money for this purpose. The taxpayer’s basis in the replacement property must be adjusted for any gain or loss recognized.

Whether gain or loss is recognized on a like-kind exchange is determined by analyzing whether all proceeds from transfer of the relinquished property are reinvested in the replacement property and no “boot” is received. There are a few types of boot, most notably, cash or mortgage boot. Boot can also include the receipt of personal property not falling within an exception. The taxpayer receives cash boot if the taxpayer actually or constructively receives cash in connection with the exchange. The taxpayer receives mortgage boot if the debt on the relinquished property is greater than the debt on the replacement property, unless additional cash in the amount of that difference is part of the exchange.

The following examples illustrate these rules:

Example 1: Refer to the table “Fully Qualified Sec. 1031 Exchange — No Debt” on page 13 for this example. The exchange qualifies under Sec. 1031 because the fair market value (FMV)/purchase price equals or exceeds the FMV/ sales price. Because the FMV/ purchase price exceeds the FMV/ sales price by $100,000, the relinquished property’s carryover basis is increased by the $100,000 of additional cash used in the exchange.

Example 2: Refer to the table “Partially Qualified Sec. 1031 Exchange — No Debt” on page 13 for this example. In this example, not all the proceeds were reinvested, thus leading to a partially taxable transaction. The taxpayer receives $100,000 on completion of the exchange. The decrease in equity represents cash boot and is taxable in the year received. The taxpayer’s basis in the replacement property is increased by the $100,000 cash boot received in the exchange.

Example 3: Refer to the table “Fully Qualified Sec. 1031 Exchange — No Change in Debt” for this example.  When debt is a factor, as it usually is with real property, it is important to understand whether the taxpayer reinvested the proceeds into property of equal or greater value, taking into account the fact that the taxpayer must also replace the amount of the debt.  Because in this example the amount of debt remains the same, there is no mortgage boot, and the taxpayer reinvested additional cash over and above the proceeds from the sale of the relinquished property to purchase the replacement property.  As in Example 1, this results in 100% deferral of gain and a $100,000 increase in the tax basis of the replacement property, attributable to the additional cash investment.

Example 4: Refer to the table “Partially Qualified Sec. 1031 Exchange — Reduction in Debt” for this example. This last example reflects a reduction in debt. The $100,000 reduction of debt is treated as additional cash, or boot, and is taxable (to the extent of gain realized on the exchange) in the year the relinquished property is transferred, even though the full $600,000 of equity was reinvested. The basis of the replacement property is increased by the amount of any such gain recognized resulting from the receipt of boot. The taxpayer can get a full deferral by using an additional $100,000 in cash to purchase replacement property worth $1,000,000. In that case, the taxpayer’s basis in the replacement property would be increased by that $100,000 cash amount (over and above its carryover basis in the relinquished property).

Many moving parts

Sec. 1031 transactions can be highly technical and complex due to various moving parts that can easily affect the intended outcome. As a result, it is advisable to consult with a tax professional and QI to fully understand the rules and requirements of like-kind exchanges under Sec. 1031.