A Section 1031 like-kind exchange is an Internal Revenue Code provision that allows a person to not pay tax on a gain when selling real property to reinvest in real property of equal or greater value. That acquisition, regardless of the type of property sold, could include rental property, vacant land, a leasehold interest in real property, even oil and gas rights.
“It’s a very broad definition as to what constitutes real property,” says Steven Dimengo, President and Managing Partner at Buckingham, Doolittle & Burroughs LLC. “It’s what we traditionally think of as real property, but all kinds of other property types as well.”
Smart Business spoke with Dimengo about like-kind exchanges, how they work and the advantages they offer.
How does a Section 1031 like-kind exchange work?
To defer all of the gains tax under Section 1031, selling real property held for investment or use in business requires that the replacement property also has to be held for investment or use in a business — it can’t be property that was inventory, for example. Financially, the exchange has to be of equal or greater in both gross value of property and equity. To the extent that an exchange doesn’t meet those requirements, whatever that deficiency is will generate boot. And boot is taxable up to the realized gain.
Exchanges are made through a third-party entity that acts as an agent to hold the funds. Similar to a bank account, interest is earned on those funds.
A potential acquisition needs to be identified within 45 days of your sale of real property — the person initiating the process tells the third-party what may be acquired, then the acquisition of the replacement property must be made within 180 days. Once the purchase agreement has been provided, the third party disperses those funds to acquire the replacement property.
The property exchanged does not need to be the same — a commercial industrial building for another commercial industrial building, for example. An industrial building can be exchanged for oil and gas rights, vacant land, a leasehold interest or an interest in a Delaware statutory trust’s real estate portfolio. These can be held passively, just like a dividend-paying stock.
What are the benefits of a like-kind exchange?
Because qualifying transactions defer all of the capital gains tax, it gives the investor much more money to work for them to generate a return. Depending on the applicable taxes, investors can retain 30 to 50 percent more of their money compared to what they would have available if selling a property outright. And it’s potentially a permanent deferral, so if the investor dies with the property in their estate (or even a subsequent replacement property), no tax is due.
However, doing these transactions just to save the tax could lock someone into a poor investment that will lead to losses, so it’s not worth it. Investments should be consistent with the person’s risk tolerance and goals, independent of the tax savings.
What is involved in the like-kind exchange process?
Like-kind exchanges can be done quickly. The documentation is straight-forward and just has to be in place before closing. And there’s time to do the planning after filing. But while it’s easy to start, there is only 45 days to identify the potential target properties and then an acquisition must be made within 180 days of your prior closing, which makes having a plan as to what to acquire as replacement property helpful — there are brokers who have lists of properties that can be reviewed for potential acquisition.
Also, it’s important to involve legal counsel when considering a like-kind exchange. To ensure that it’s done correctly and capture the full benefit, the parties must meet certain requirements. Sometimes there can be issues on the fringes as to whether a property might qualify. Additionally, there is a lot of planning associated with Section 1031 to make sure that it’s implemented correctly; the third-party exchange companies are not going to do that.
Like-kind exchanges are much simpler than many think, and they’re not as restrictive as many believe. These can be used to exit a more involved investment, such as rental properties, and enter more passive investments — like holding stock that pays dividends — and the investment options are very broad. ●
INSIGHTS Legal Affairs is brought to you by Buckingham, Doolittle & Burroughs LLC.
