Currently, owners of real property used for business or held as an investment can potentially exchange property of the same type, tax free. This “swap” falls under the guidance of Internal Revenue Code (IRC) Section 1031, which allows participants in the exchange to avoid gain assuming no additional property (cash, personal property, intangible property, etc.) is transferred in the transaction. Even if the properties included in the exchange qualify as like-kind, there are additional requirements surrounding the transaction that must be met to avoid gain.
The first hurdle for Section 1031 gain deferral is for the assets to qualify as like-kind real property. Historically, like-kind exchanges were possible with personal property—for example, vehicles or heavy machinery. However, the Tax Cuts and Jobs Act of 2017 modified Section 1031 to exclusively include only real property in like-kind exchanges. Real property for this purpose is defined as land, permanent structures on land, structural components of these structures, certain intangible interests in these properties, among other similar property.1 Included as qualified real property is everything from the crops growing on the exchanged land to an easement or leasehold of real property. This property can be held for either investment or for use in a trade or business, but not primarily held for sale. While the properties must both have substantially the same character, they can have different quality or improvement.2
If the exchange is not simultaneous—meaning the taxpayer relinquishes property without receiving replacement property at the same time—the transaction is a deferred exchange. There are further requirements for deferred exchanges. The replacement property must be both identified within 45 days and acquired 1) within 180 days of the transfer of the relinquished property, or 2) by the due date (without considering any extensions) of the tax return for the year the transfer occurs. The identification process allows for the taxpayer to identify multiple properties in connection with meeting the 45 day identification period requirement. In this situation, the taxpayer can either identify “1) Three properties without regard to the fair market values of the properties (the “3-property rule”), or 2) Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer (the “200-percent rule”).”3 Either way, following the 45 day identification period, the replacement property must be acquired timely to avoid gain recognition.
Deferred exchanges present a special hurdle to preventing gain. If at any point in the transaction the seller has constructive receipt of money or property not meeting the Section 1031(a) requirements prior to receiving the replacement like-kind property, then the seller must recognize income to the extent of that money or property. Constructive receipt essentially means that the taxpayer has control over, or a right to use or demand, money or property. In essence, if proceeds are received for the amount of the property transferred prior to receiving the replacement property, then the transaction could be considered a sale. There are four methodologies, or “safe harbors” that allow taxpayers to avoid constructive receipt.
The four safe harbors are:
- Security or guarantee arrangements
- Qualified escrow accounts and qualified trusts
- Qualified intermediaries
- Interest and growth factors
The most common of the four is a qualified intermediary (QI). QIs are not agents of the taxpayer; they facilitate the transfer of the properties and keep the taxpayer from accessing the economic benefit of any money or property until the replacement property is received. An individual would not be considered a qualified intermediary if deemed a disqualified person, “a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent within the 2-year period ending on the date of the transfer of the first relinquished property.”4 Related parties are also considered disqualified parties. Related parties for this purpose are any persons that have a relationship with the taxpayer as defined in Section 267(b) or Section 707(b) except that 10% is substituted in the case of any instance of 50%. For example, this would include certain family members of the taxpayer, a corporation where the taxpayer directly or indirectly owns more than 10% of the value of the outstanding stock, or a fiduciary of a trust for which the taxpayer is the grantor.
Overall, it is important to know how you can qualify for a Section 1031 exchange. From there, the actual reporting and calculation of any resulting gain can be complicated. Factors such as debt forgiven or assumed, basis in the properties, or cash can all affect the tax impact of the transaction on the taxpayer. Also, care must be taken in connection with the mechanics of the transaction so that gain is not accidentally triggered. Therefore, while Section 1031 transactions can be beneficial, it is important to involve your Forvis Mazars advisor early when considering these transactions.
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