1031 Tax Deferred Exchange – Part 1
By BPE Law Attorney Matthew Kirkpatrick
Clients often come to us with business or investment property that is under-performing. The client wants to continue the investment but feels that a new property would generate a higher rate of return. The client’s perceived problem is that as soon as they sell the property, they will get hit with a capital gains tax. The good news is that the tax code provides a “non-recognition” provision to alleviate this exact predicament.
Section 1031 of the tax code allows a taxpayer to “exchange” “business or investment” property for a “like kind” property without paying a capital gains tax. There are three elements that must be met in order to swap out one business property for another without recognizing any gain on the sale. But first, let’s clarify some Common Terms that will apply.
This tax provision has created a cottage industry with its own terms and lingo. First of all, the whole transaction is called a “1031 exchange.” The 1031 exchange is governed by the Internal Revenue Code, called the “IRC” or “Tax Code” and enforced by the Internal Revenue Service, the “IRS”, with guidance from the IRS Regulations, called the “Regs.” The party seeking non-recognition of income is known as the “taxpayer.” To facilitate the transaction the parties will often hire a “Qualified Intermediary” to act in a capacity similar to that of an escrow agent. The property that is being sold by the taxpayer is formally known as the “relinquished property” in the IRS regulations, but in practice is commonly called the “downleg property.” Similarly, the property acquired by the taxpayer is the “replacement property” or “upleg property.”
Now for the three elements required for a successful 1031 Exchange:
1. Productive Trade or Business
The first requirement to receive 1031 non-recognition is that the “property is held for the productive use in a trade or business or for investment.” IRC §1031(a)(1). This is a fairly broad requirement and typically covers any profit seeking property. The biggest assets for the majority of taxpayers that will not qualify for a 1031 exchange will be their personal residence, vacation homes, and personal vehicles.
The second element requires that the disposition must qualify as an “exchange”. IRC §1031(a)(1). It has long been held that “in a sale, the property is transferred in consideration of a definite price expressed in terms of money, while in an exchange, the property is transferred in return for other property without the intervention of money.” Bloomington Coca-Cola Bottling Co. v. Commissioner, (1951) 189 F.3d 14, 16. However, the presence in a transaction of a small amount of cash, to adjust certain differences in value of the properties exchanged will not necessarily prevent the transaction from being considered an exchange.” Bloomington Coca-Cola Bottling Co. v. Commissioner, (1951) 189 F.3d 14, 16. Although not called this in the IRC or in the Regs, the “small amount of cash” is commonly referred to as “boot”. The boot will not disqualify the transaction from being a 1031 exchange, but the value of the boot is recognized as income.
3. Like Kind
Lastly, the upleg and downleg properties must be “of like kind.” IRC §1031(a). “Like kind” has been interpreted very broadly as to real estate exchanges and generally real property exchanges are considered “like kind”. Regs §1.1031(a)-1(b). However, the standard for personal property (everything that is not real property) is held to a fairly strict standard. For example, depreciable property must be within the same depreciation asset class and male and female livestock have been held to not be of “like kind”.
The Capital Gain is not Forgiven – As a final important factor to understand is that a 1031 Exchange does not extinguish capital gains tax liability. Rather, the exchange takes the amount of capital gain in the downleg property and reduces the taxable basis of the upleg property by an equivalent amount. Thus when the upleg property is later sold, the deferred capital gain is “recaptured” and taxed along with any capital gain that may have been obtained during ownership of the upleg property. Of course, if the upleg property is also sold through a 1031 Exchange, the entire combined capital gains may pass forward to the new upleg property assuming that the value is high enough. Lastly, under one circumstance, the capital gain may actually be forgiven when the property is inherited following the death of the owner. Then a separate tax law may grant the heirs a “stepped-up basis” wiping out the entire capital gain.
If you would like to know more, please feel free to contact Matt by e-mail to firstname.lastname@example.org or call our main office at 916-966-2260 to schedule a low-cost Consultation appointment either in our Fair Oaks or Sun City Lincoln office.
The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are facing a legal issue of any kind, get competent legal advice in your State immediately so that you can determine your best options.