As real estate professionals, we have a fiduciary responsibility to help our clients achieve their goals relating to real property. Often times, these goals revolve around maximizing the return the client will achieve either during the acquisition or disposition of their real estate assets. A valuable tool in this process is the like-kind exchange. This tool could permit non-recognition of a gain for tax purposes, allowing our clients to invest ALL of the proceeds from a sale into a new asset.
As land professionals, many of us encounter owners of raw land assets that generate very little cash flow, or worse, don’t have potential to generate income. The ability to sell this passive asset without any tax exposure and exchange into a cash flow asset such as an apartment building or net leased shopping center is a power motivator that can in many cases, substantially increase our client’s income and positively impact their lives.
As investors, it is imperative that you seek the guidance of your tax advisor, a Qualified Intermediary (QI), and a real estate professional well before considering a disposition or acquisition to ensure the transaction is structured appropriately to achieve your overall financial goals.
What is a 1031 Exchange?
Since 1921, Internal Revenue Code (IRC) Section 1031 provides for the opportunity to defer payment of capital gains tax liability by reinvesting the proceeds from the sale of a relinquished property into another similar asset. There are many nuances to the code but generally, to exchange from one asset to another, the proceeds of a sale must be reinvested into a “like-kind” property. “Like-kind” refers to the character of the asset, not the quality. For example, property purchased and held for investment purposes may be exchanged for another investment property. The properties can be land, apartments, or different so long as they are both held for investment. Conversely, a primary residence being sold and exchange into an investment asset would NOT qualify. So long as the process is followed, the taxes are not eliminated but payment of the taxes is delayed until such time as the gain is realized when the acquired asset is sold, without being exchanged further.
This does not require an investor to trade their real estate straight across or sell their relinquished property and acquire a replacement property at the same time. By using a QI, investors are given a certain period of time to complete the acquisition of their replacement property.
What is a 1033 Exchange?
Similar to IRC Section 1031, Section 1033 provides for non-recognition of gains and deferral of the tax liability. The primary difference is that a 1033 exchange can be used only when the property is being relinquished through a “forced-conversion.” Examples of “forced-conversion” would be taking by eminent domain or loss from a natural disaster, even if insurance proceeds are received.
While similar, there are distinct differences between the two. Below are highlights of some of the rules and how they differ between the 1031 and 1033 exchange.
|Use||Exchange of real property held for productive use in a trade or business or for investment.||Exchange of property compulsorily or involuntarily converted as a result of eminent domain, destruction, or theft.|
|“Even and Up Rule” – Equity||Equity in the replacement property must be even to or greater than the net equity of the relinquished property.
Equity cannot be replaced with additional debt.
|Cost of the replacement property must be even to or greater than the net proceeds received.
Equity can be replaced with additional debt.
|“Even and Up Rule” – Debt||The amount of debt on the replacement property must be even to or greater than the amount of debt relieved on the relinquished property.
Debt can be replaced with additional equity (i.e. cash).
|The value of debt on the replacement property must be even to or greater than the value of debt relieved on the property converted.
Debt can be replaced with additional equity (i.e. cash).
|Replacement Property Criteria||Like-Kind||Similar or related in service or use|
|Notification Period||Within 45 days of the disposition, must notify the Qualified Intermediary of the potential replacement properties.||Identification of potential replacement properties is not required.|
|Timing||Within 180 days of disposition, escrow must close on all replacement property.||Within 2 years from the end of the first tax year in which gain is realized, escrow must close on all replacement properties. Special rules extend this period to 3 or 4 years.|
|Vesting||The same taxpayer that sold the relinquished property must purchase the replacement property.||The same taxpayer that sold the relinquished property must purchase the replacement property.|
|Improvements||Exchange funds cannot be used to improve land already owned.||Conversion proceeds can be used to improve land already owned.|
|Related Parties||In most cases, the replacement property cannot be acquired from a related entity.||In most cases, the replacement property cannot be acquired from a related entity.|
Reverse 1031 Exchange
On September 15, 2000, the Internal Revenue Service issued Revenue Procedure 2000-37. This explains how to complete a “Reverse 1031 Exchange,” a scenario where an investor acquires the replacement property prior to selling the relinquished property. In this scenario, a QI (through a special purpose entity) will act as the Exchange Accommodation Titleholder, acquire and hold or “park” legal title to either the relinquished property or the like-kind replacement property during the exchange. This structure is more expensive and complex than a traditional exchange and should be reviewed with a tax advisor to ensure the investor’s specific situation warrants use of this structure.
Tax Cuts and Jobs Act
Signed into law on December 22, 2017 The Tax Cut and Jobs Act took effect on January 1, 2018 and substantially modified the IRC. Specific to Section 1031, the act eliminated personal property exchanges, limiting the ability to exchange assets to only real estate. It is now titled, “Exchange of real property held for productive use or investment.” However, certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible for non-recognition of gain as like-kind exchanges, if considered to be real property under applicable state law.
State specifics and claw-back provisions
Particular care should be given to exchanges involving relinquished property and replacement property in different states. Many states have withholding requirements applicable to non-residents. Although most states allow investors to sell property in that state and exchange into property in another state and defer state taxes, some states have claw-back laws. Claw-back laws permit a state to recapture the state income tax when the out of state replacement property is sold. To avoid potential double taxation, it is critical for an investor to research how the states they are dealing with treat these transactions.
This article is intended to be a primer on like-kind exchanges and highlight some of the nuances and considerations needed to successfully complete these transactions. Nothing in this article should be considered tax or legal advice and any investor interested in learning more about exchanges should speak with their tax adviser and a Qualified Intermediary.
About the Author: Matt Davis is a real estate broker with Cushman & Wakefield. He is based in San Diego, CA and assists clients with the disposition and acquisition of investment grade agricultural and transitional land assets. He is also founding member of the company’s Land Advisory Group and Agribusiness Solutions Team. Matt is a member of RLI and serves on their 2019 Future Leaders Committee.