One of the many changes from the Tax Cuts and Jobs Act (TCJA) is the limitation of property eligible for like-kind exchange tax treatment. Prior to the TCJA, the like-kind exchange rule allowed for a deferral of gain, to the extent that business property, which ranged from real estate to tangible personal property, was exchanged for business property of a like kind, until it was ultimately sold. Under the TCJA, like-kind exchange treatment is limited to the exchange of real property (land and buildings) held for productive use in a trade or business or for investment solely for real property of like kind. Congress felt that businesses received the benefit of deducting all of the cost of personal property through the increased Section 179 expensing limits and 100% bonus depreciation on new and used property. Therefore, exchanges of business autos and other tangible personal property (machinery, equipment, intangible assets, etc.) entered into after December 31, 2017 do not qualify for tax deferral treatment. The taxpayer will now have a recognized gain or loss on exchanges of personal property, such as a traded-in auto, depending on its trade-in value and remaining basis.
Congress intended that real property eligible for like-kind exchange treatment under pre-Tax Cuts and Jobs Act law would continue to be eligible. Therefore, no gain or loss is recognized on the exchange of real property if all of the following requirements are satisfied:
- The transaction must in fact be a reciprocal exchange of real property
- The exchange must be for like-kind real property
- Both the real property transferred (the relinquished property) and the real property received (replacement property) must be held for productive use in a trade or business or for investment
- The real property cannot be property held primarily for sale
A transfer of property meeting these requirements can qualify as tax-free even though the taxpayer also transfers property not meeting those requirements or money (i.e. boot).
Like-kind property must be both given up as relinquished property and received as replacement property in a transaction in order to satisfy the “exchange” requirement. It is important to have the taxpayer who owns the relinquished property receive the replacement property. For example, where a partnership distributed property to its partners who in turn exchanged it for like-kind property, the Tax Court held that the partnership, not the partners, disposed of the relinquished property. Therefore, the partners would be entitled to exchange treatment only if the partnership satisfied the requirements of like-kind exchange tax treatment. Since the partnership did not receive like-kind property in the exchange, (the partners received the like-kind replacement property), the partnership never “exchanged” like-kind property and the nonrecognition rules did not apply (Chase, Delwin G., (1989) 92 TC 874).
Like-kind exchanges do not need to be simultaneous. Nonrecognition treatment applies to deferred like-kind exchanges if the property to be received meets the identification requirement and the exchange is completed within certain time limits (receipt requirement). Deferred exchanges can qualify for nonrecognition if the replacement property is:
- Identified within 45 days after the date the taxpayer transfers the relinquished property in the exchange
- Acquired 180 days after the transfer of the relinquished property
To be treated as a deferred exchange, a transaction has to be an exchange of property as distinguished from a transfer of property for money. Therefore, a sale of property followed by a purchase of property that is of a like kind to the property sold does not qualify for nonrecognition of gain or loss even if the other requirements for a like-kind exchange are met.
The use of a qualified intermediary is the most common method to easily complete a valid tax-free deferred exchange. A qualified intermediary (QI) is a person who is not the taxpayer and who enters into a written agreement with the taxpayer (called the exchange agreement) under the terms of which the intermediary:
- Acquires the property to be relinquished from the taxpayer,
- Transfers the relinquished property,
- Acquires the replacement property, and
- Transfers the replacement property to the taxpayer.
The QI that is the transferee of the relinquished property (item 2 above) and the QI that is the transferor of the replacement property (item 4 above) have to be the same person. The steps to facilitate a deferred 1031 exchange with a qualified intermediary are as follows:
- Taxpayer signs a contract to sell an asset to the buyer
- Prior to the property closing, the taxpayer retains a QI
- At the closing, the funds are sent to the QI
- Within 45 days after the transfer of the relinquished property, the taxpayer identifies a replacement property
- Within 180 days from the transfer date of the relinquished property, the taxpayer acquires any and all replacement properties
- At the closing of the replacement property, the QI sends the funds to complete the exchange
If, in addition to receiving like-kind real property, a taxpayer transferring real property in a like-kind exchange receives money or non-like-kind property (boot), the taxpayer recognizes gain to the extent of the money and the fair market value of the non-like-kind replacement property received. A loss is not recognized. If the other party to the exchange assumes a liability of the taxpayer, the taxpayer is treated as having received boot. Generally, gain that is deferred through a like-kind exchange will not be subject to the net investment income tax (NIIT). Any realized gain that has to be recognized as boot can be subject to the NIIT.
The basis of real property received (replacement property) in a tax-free like-kind exchange is generally the basis of the real property transferred (relinquished property). The basis is increased for additional consideration given and gain recognized (boot) and decreased for money received. The amount of any of the taxpayer’s liabilities assumed by the other party to the exchanges is treated as money received by the taxpayer and decreases the replacement property’s basis.
In the case of exchanges between related persons, nonrecognition treatment under code section 1031 does not apply if either the property transferred or the property received is disposed of within two years after the exchange. Therefore, a gain or loss on an exchange between related parties must generally be recognized if either the property transferred or the property received is disposed of within two years after the exchange. This rule is intended to deny nonrecognition treatment for transactions in which related parties make like-kind exchanges of high-basis property for low-basis property in anticipation of the sale of the low-basis property.
Although the TCJA eliminated the tax-deferred like-kind exchange treatment for personal property transactions, like-kind exchanges will continue to be an effective means of deferring gain on real estate dispositions. Prior to entering into a like-kind exchange of real property, it is important to consult your tax advisor since these transactions are complex and involve a lot of planning.
Gloria Nostramo is a principal based out of our Albany, NY office.