There’s something therapeutic about whacking a ping-pong ball with a tiny paddle — slamming it like a right hook. It’s even more satisfying to bounce real estate holdings back and forth, using IRC Section 1031 rules for like-kind exchanges, and walk away with a winning tax deferral.
Unfortunately, Section 1031 exchanges are far more complicated than ping-pong, and recent statutory and regulatory changes have left a lot of folks scratching their heads. When industry folks talk about these transactions, we use terms like “1031 exchange,” “deferred exchange,” and “like-kind exchange” interchangeably. But what do they all mean?
A Section 1031 exchange requires two steps:
- First, a taxpayer sells property (the relinquished property) that was held for investment or used in a trade or business.
- Next, using the proceeds from that sale, the taxpayer purchases a similar (“like-kind”) replacement property of greater or equal value within 180 days.
If all the right conditions are met, IRC Section 1031 defers the gain on the sale of the relinquished property, so that tax is not due until the replacement property is later sold in a taxable transaction.
Like-kind property is a very broad term requiring that the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” In other words, you can exchange almost any type of real property for another type of real property, as long as it’s not personal property.
What’s the History Behind These Exchanges?
Section 1031 was originally enacted in 1921, spurring significant economic growth in the last century. Often demonized as a tax break for the wealthy, these exchanges are primarily used by smaller investors looking to maximize cash flow. (More than 60% of 1031 exchanges involved properties worth less than $1 million.) Owners of domestic real estate are encouraged by the tax benefits to reinvest in U.S. real estate, because only U.S. investments are eligible. For example, an automobile manufacturer cannot receive tax deferral benefits by closing a Michigan plant and moving the facility to another country.
Before the infamous Tax Cuts & Jobs Act (TCJA) of 2017, Section 1031 allowed other kinds of assets to qualify. Post-TCJA, though, only real estate assets can qualify to defer gains. Many investors feared the provision would evaporate entirely, nervously working to complete Section 1031 exchanges before the TCJA passed, just in case. In the end, Section 1031 remained, but only real estate assets survived the legislative knife. Score a win for the real estate industry lobby!
Taking a 1031 Exchange Journey
The Countdown Begins
What happens in a Section 1031 exchange? Here’s a sample timeline for a successful property exchange. Note that there are two key deadlines: 45 days and 180 days after the first property is sold.
Day 1: The Initial Sale
The journey begins when the relinquished property is sold. To qualify for 1031 treatment, the relinquished real property must be either used in a trade or business or held for investment. The sales proceeds must be deposited with a qualified intermediary that will hold the money that will later be used to buy a replacement property. If the relinquished property had a mortgage that was paid off at the first closing, the net proceeds are deposited into an exchange escrow account held by the qualified intermediary.
Note that in order to qualify for deferring gains, the taxpayer must reinvest in replacement property of equal value to the relinquished property. If the amount in escrow isn’t enough to pay for the replacement (for example, because a mortgage was also paid out of the sales proceeds), then the taxpayer will need to either furnish cash or secure a loan to fund the rest of the purchase. If there is more money in escrow than the replacement costs, that leftover “boot” is a gain that cannot be deferred.
Day 45: Identifying the Replacement
Within 45 days of the sale, the exchanger must identify the replacement property. And there are specific rules and exceptions to consider. In a nutshell:
- The three-property rule allows you to identify three properties as potential purchases regardless of their market value.
- The 200% rule allows you to identify unlimited replacement properties as long as their cumulative value doesn’t exceed 200% of the value of the property sold.
- The 95% rule allows you to identify as many properties as you like with a total value more than 200% of the relinquished property, but stipulates that 95% of the market value of all properties identified must be acquired. Yes, you can acquire more than one replacement property. (And no, this is not a commonly used option.)
Within 180 days of selling the relinquished property, the exchanger must complete the purchase of the replacement property. Note that both of these deadlines are based on the initial sales date, so if you wait until Day 45 to identify a replacement, you have just 135 days to close the second transaction.
What’s the Catch?
Seems straightforward, right? Not so fast. First, what exactly qualifies as real property? The 2017 TCJA spawned a whole new series of IRS guidance supposedly clarifying the new rules. In November 2020, the IRS issued final regulations on various questions and issues related to these exchanges. Here are a few key things to know:
Q: How do the new regulations define “real property” for purposes of Section 1031?
A: “Real property” includes land and improvements to land, un-severed natural products of land, and water and air space above land. An intangible interest in real property described above, certain permits and licenses to use inherently permanent structures, and property that is real property under state or local law are all included.
Q: What is are considered “improvements to land”?
A: Improvements include “inherently permanent structures” and the “structural components” thereof. Inherently permanent structures means any building or structure that is a distinct asset and is a) permanently affixed to real property and b) 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.
To leave no stone unturned, the regulations further define a building as any structure or edifice 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. These could be any kind of buildings, from factories to stores to barns, as long as they’re permanently affixed. Movable structures, such as a trailer or mobile home, wouldn’t count.
Q: There are still stores in the world?
A: Yes, but check back in a year and we’ll see if any are left.
Q: What are some example of permanently affixed structures?
A: The following are just a few examples considered to be “inherently permanent structures” if permanently affixed to land: In-ground swimming pools, bridges, paved parking areas, parking facilities, stationary wharves and docks, permanent outdoor lighting facilities, broadcast or transmission towers, oil and gas pipelines, and grain storage bins. The proposed rules lay out criteria for determining what is inherently permanent, such as how much damage would be caused by removing it.
Q: What about machinery, equipment or other property ordinarily considered to be personal?
A: The final regulations say as long as it is permanently affixed to real property and will ordinarily remain affixed for an indefinite period of time, it counts as part of the real estate.
Q: How do the regulations define a “structural component”?
A: Structural components are what you would expect: walls and ceilings; partitions; doors; wiring; plumbing systems; central air conditioning and heating systems; pipes and ducts; elevators and escalators; fire suppression systems, including sprinkler systems and fire alarms; and the like.
Q: So what is considered personal property? And how does depreciation fit in?
The proposed rules say that personal property isn’t defined by use but includes anything that isn’t real property: furniture, fixtures, appliances, moveable walls and partitions, and certain property related to the functional use of otherwise personal property.
In the context of, say, a medical surgery center, there may be certain outlets and gas lines installed for use with specific (removable) medical equipment. Those outlets and gas lines relate to the use of personal property, and may also be classified (and depreciated) as personal rather than real property. So, while the outlets and gas lines may be depreciated as personal property, for purposes of Section 1031 the assets are structural components and treated as real property.
An Example and a Warning
Suppose that a taxpayer seeking Section 1031 treatment purchases an office building as replacement property, and it includes office furniture and other items that are not real property.
Fortunately, the regulations say that if the aggregate fair market value of the personal property received does not exceed 15 percent of the aggregate value of the replacement, then the transaction will still qualify for Section 1031. However, the use of exchange proceeds to acquire property other than real estate may result in a taxable gain on the boot (leftover sales proceeds).
Pro tip: To avoid the mess of dealing with mixing real and personal property in the same transaction, bifurcate the sale into two pieces: one transaction for the real property (the Section 1031 exchange), and a second transaction to transfer the personal property.
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