Like-Kind Exchanges Flashcards
What are Like-Kind Exchanges deferral or exclusion
The three most common deferral or exclusion transactions in the tax code are:
- Like-kind exchanges under Section 1031 (deferred gain or loss)
- Involuntary conversions under Section 1033 (deferred gain)
- Sales of a personal residence under Section 121 (excluded gain)
What is Section 1031 (a)
Section 1031(a) of the Internal Revenue Code (IRC) says that “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such 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.”
Section 1031 is not an elective provision. If the exchange qualifies as a like-kind exchange, non-recognition of gain or loss is mandatory.
Character of the Property
The property exchanged must be like-kind to be a non-taxable exchange under Section 1031. The Treasury Regulations specify: “the words ‘like-kind’ have reference to the nature, or character of the property and not to its grade or quality.” Thus, exchanges of real property qualify even if the properties are dissimilar.
For example, Eric owns an apartment building held for investment. Eric exchanges the building for farmland to be used in his trade or business. The exchange is a like-kind exchange because both the building and the farmland are classified as real property and both properties are used either in business or held for investment.
Both property needs to be in the USA.
Exchanges of Securities (Section 1036)
The like-kind exchange rules do not apply to stocks, bonds or notes. However, Section 1036 provides that no gain or loss is recognized on the exchange of common stock for common stock, or preferred stock for preferred stock in the same corporation. Section 1036 applies even if voting common stock is exchanged for non-voting common stock of the same corporation. The non-taxable exchange of stock of the same corporation may be between two stockholders or a stockholder and the corporation.
Qualification for Section 1031
To qualify as a like-kind exchange, a direct exchange of property must occur. Thus, the sale of property and the subsequent purchase of like-kind property do not qualify as a like-kind exchange unless the two transactions are interdependent.
The IRS indicates that a non-taxable exchange may exist when the taxpayer sells property to a dealer and then purchases like-kind property from the same dealer.
A sale of property and subsequent purchase of like-kind property may be treated as like-kind exchange if the two transactions are interdependent.
Non-simultaneous Exchange
The most common like-kind exchange of real estate is a non-simultaneous exchange. The rules for such exchanges have been clarified as a result of the Tax Reform Act of 1984. A non-simultaneous exchange is a like-kind exchange, if the exchange is completed within a specified period. The property to be received in the exchange must be identified within 45 days after the date of the transfer of the property relinquished in the exchange. The replacement property must be received within the earlier 180 days, after the date the taxpayer transfers the property relinquished in the exchange or the due date for filing a return (including extensions) for the year in which the transfer of the relinquished property occurs. Most importantly, the person claiming the like-kind exchange may not control the proceeds of the first exchange during the time between the non-simultaneous exchanges.
For example, on May 5, 2024, Joel transfers property to Lauren, who transfers cash to an escrow agent (who may not be an agent of Joel, such as his attorney or accountant). The escrow agent is to purchase suitable like-kind property for Joel. Joel does not have actual or constructive receipt of the cash during the delayed period. To be a like-kind exchange for Joel, the suitable like-kind property must be identified by June 19, 2024 (45 days after the transfer) and Joel must receive the property by November 1, 2024 (180 days after the transfer).
Timing consideration of a non-simultaneous exchange
In a non-simultaneous exchange or deferred exchange, the exchanger has 45 days from the date that the relinquished property closes to identify the replacement property or properties and 180 days from the closing date of the relinquished property to close on the replacement property.
What is receipt of “Boot”
Taxpayers who want to exchange property do not always own property of equal value. To complete the exchange, non-like-kind property or money may be given or received. Cash and non-like-kind property constitute boot.
Gain is recognized to the extent of the boot received. However, the amount of recognized gain is limited to the amount of the taxpayer’s realized gain. In effect, the realized gain serves as a ceiling for the amount of the recognized gain. The receipt of boot as part of a non-taxable exchange does not cause a realized loss to be recognized.
For example, Mario exchanges a parking lot with a $500,000 adjusted basis for $100,000 cash and an apartment building with a $650,000 FMV. The realized gain is $250,000 ($750,000 − $500,000). Because the $100,000 of boot received is less than the $250,000 of realized gain, the recognized gain is $100,000.
Mary exchanges a parking lot with a $700,000 adjusted basis for $200,000 cash and an apartment building with a $650,000 FMV. Her realized gain is $150,000 ($850,000 − $700,000). Because the $200,000 of boot received is more than the $150,000 of realized gain, only $150,000 of gain is recognized.
Basis of the Property Received
Basis of property in a non-taxable exchange = Basis of property exchanged − Boot received + Gain recognized − Loss recognized
How long must related parties hold on to like-kind property after an exchange in order for it to be considered a like-kind exchange?
2 years
Transfer of Non-Like-Kind Property
If the taxpayer transfers non-like-kind property, gain or loss equal to the difference between the FMV and the adjusted basis of the non-like-kind property surrendered must be recognized. But, if the non-like-kind property is a personal use asset, the loss is not recognized.
What is the sales of a personal residence under Section 121 (excluded gain)
This provision allows qualified homeowners to exclude as much as $500,000 in capital gains from taxation after the sale of their primary residence. Considering the maximum capital gains tax rate of 20%, a section 121 exclusion may present a six-figure tax savings opportunity—depending on eligibility
What is the Involuntary conversions under Section 1033 (deferred gain)
An involuntary conversion occurs when your property is destroyed, stolen, condemned, or disposed of under the threat of condemnation and you receive other property or money in payment, such as insurance or a condemnation award.
