Real Property Tax Strategies: The 1031 Exchanges

Benjamin Franklin once said, “Our new Constitution is now established, everything seems to promise it will be durable; but, in this world, nothing is certain except death and taxes.” Franklin may have been correct regarding the certainty of death, but was he correct about the certainty of taxes?

Many savvy taxpayers and investors have found a way to pass down immense amounts of property wealth to their heirs and avoid paying taxes altogether. What I am referring to is known as a like-kind exchange or Section 1031 exchange. I will explain in further detail how this has been used as a tool to build generational wealth, but we should first examine the transaction itself.

The name of the transaction comes from IRC section 1031. This code section states in part, “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

This is indeed a mouthful, but what it primarily means is you can defer the payment of capital gains on the sale of property if you purchase a like-kind property and follow the requirements and properly execute the transaction.

At a basic level, to accomplish a section 1031 exchange, there must be an exchange of properties. The property that you sell and the new property you acquire must meet certain requirements. Both of the properties must be held for use in a trade or business. This is an important rule to remember because properties that are primarily used for personal use will not qualify for the beneficial tax treatment.

The properties involved in the exchange must be similar enough in nature, character, or class. This doesn’t mean that the financial value of the properties must be similar. For example, you could sell a $1 million apartment complex and purchase a new apartment complex for $10 million and still receive the treatment.

Real properties generally are like-kind, regardless of whether they’re improved or unimproved. For example, a vacant parcel of land is like-kind to a parcel of real property that has improvements such as residential rental units. However, real property in the United States is not like-kind to real property outside the United States.

In order to report a like-kind exchange, taxpayers need to complete Form 8824, which can be downloaded from the IRS website. The form itself is rather simple to complete and is only two pages; however, there are several requirements that taxpayers need to keep in mind before completing a like-kind exchange. I typically recommend to my clients to use professionals when they are considering a like-kind exchange.

Timing is one crucial aspect of this transaction. The clock starts ticking when you initially complete the sale of your property. You must identify a replacement property within 45 days of the sale date. If more than one property is sold during one exchange, the 45 days start counting from the date the first property closes.

There are different rules regarding how many properties the taxpayer can identify as replacement properties, but the most important thing to remember is to identify a replacement within 45 days. The purchase of the new property must be concluded within 180 days of the sale of the first property. This makes prior planning and identifying replacement properties ahead of time of great importance.

Additionally, you must have a qualified intermediary assist you with the transaction. A qualified intermediary is a person or company that helps facilitate the 1031 exchange by holding the funds until they can be transferred to the seller of the replacement property.

Under section 1031, any proceeds received from the sale of the property remain taxable. Instead of the taxpayer receiving the proceeds, the funds must be transferred to a qualified intermediary who then transfers the funds to the seller of the property. If the party selling the property receives the proceeds directly, the taxpayer will not qualify for the like-kind exchange.

Typically, if a taxpayer sells an asset such as real property, he or she pays what is known as a capital gains tax. In general, a capital gain tax is the tax you pay on the sale of an asset that has increased in value since the time you initially purchased it.

Capital gains rates vary depending on your income and filing status. Taxpayers only pay a capital gains tax on an asset after it is sold. This is when the 1031 exchange can become a very useful tool in deferring (at least for the time being) paying capital gains on the sale and purchase of like-kind properties.

So, how beneficial can this transaction be? The tax doesn’t go away forever; it is simply deferred. Once you decide to sell the replacement property (that is not part of a new 1031 transaction), the original amount of deferred gain plus gain realized on the new property is subject to the capital gains tax. However, some taxpayers have found a way to avoid paying the tax by passing it down to heirs upon death.

This is a major beneficial tool in passing down generational wealth. Once your heirs inherit property received through a 1031 exchange, the value of the property is “stepped up” to fair market value, which wipes out the entire tax deferment debt. Instead of having the original tax basis of the purchased properties, they are now inherited at fair market value.

Imagine if a person has been buying and selling properties throughout their entire life using this transaction. All the capital gains on the sales of the properties have been deferred. If that person was living and decided to sell their properties, they would likely be looking at some massive capital gains tax bills. Instead, they use estate planners to transfer the properties to their heirs upon their death. It’s hard to overstate the amount of tax benefit this can have.

One important update to note is that under the Tax Cuts and Jobs Act of 2017, Section 1031 now applies only to exchanges of real property and not to exchanges of personal or intangible property. An exchange of real property held primarily for sale still does not qualify as a like-kind exchange.

Before the passage of this legislation, the rules applied to other tangible property such as machinery, equipment, vehicles, and artwork. Now the rules only apply to the exchange of a business or real estate investment property. This change became effective on January 1, 2018.

A transition rule in the new law provides that Section 1031 applies to a qualifying exchange of personal or intangible property if the taxpayer disposed of the exchanged property on or before December 31, 2017, or received replacement property on or before that date.

There are times when you can receive a partial deferral of capital gains but also recognize some immediate gains as well. For example, if you sell a property and the new property that you purchase costs less than the sale price of the property you sold, you will have a taxable event.

The way to get a full deferral is to buy a new property that is equal to or more expensive than the property you sell. For example, imagine that you purchased a property for $500,000. Later on, you sell the property for $1 million, and you purchase a new property for $900,000.

In this case you would immediately recognize a gain of $100,000 and would defer the gain on $400,000. It is important to note that these transactions can become much more complex, but that is outside the scope of this general overview.

If done correctly, there is no limit on how many times you can execute this transaction and continue to defer capital gains. This can allow your investment to continue to grow with the tax-deferred treatment.

If you do decide to sell a property that received the 1031 treatment, it is beneficial to pay long-term capital gains rates. If you hold the asset for more than one year, you will receive the preferable long-term capital gain rate. If you hold the asset for less than one year, you will pay short-term capital gains rates. If this is the case, the tax rate will be the same as your ordinary income tax rate based on your current tax bracket.

Section 1031 was first created in 1921 after being adopted by Congress as part of the Revenue Act of 1918; however, the future of this transaction is uncertain.

Recently, President Joe Biden unveiled an economic plan that would eliminate the right to defer tax payments on investment gains of more than $500,000. Biden also wants to close another death loophole by taxing capital gains on inherited assets.

The Biden administration wants to end the ability to “step up” the cost basis for real estate when it is inherited. This could have serious tax consequences for anyone inheriting real estate. For tax professionals it will be especially important to keep an eye on any legislative activity regarding the 1031 exchange. 

PUBLISHED IN GPSOLO, VOLUME 38, NUMBER 6, NOVEMBER/DECEMBER 2021 © 2021 BY THE AMERICAN BAR ASSOCIATION. REPRODUCED WITH PERMISSION. ALL RIGHTS RESERVED. THIS INFORMATION OR ANY PORTION THEREOF MAY NOT BE COPIED OR DISSEMINATED IN ANY FORM OR BY ANY MEANS OR STORED IN AN ELECTRONIC DATABASE OR RETRIEVAL SYSTEM WITHOUT THE EXPRESS WRITTEN CONSENT OF THE AMERICAN BAR ASSOCIATION