(Nov. 9, 2018) Since 1921, U.S. tax law has recognized that the exchange of one investment or business-use property for another of like-kind results in no change in the economic position of the taxpayer, and therefore, should not result in the immediate imposition of income tax.
The exchange rules permit the deferral of taxes, so long as the taxpayer satisfies numerous requirements and consummates both a sale and purchase within 180 days. This is often referred to as a 1031 Like-Kind Exchange.
To accomplish a Section 1031 exchange, there must be an exchange of properties.
The simplest type of Section 1031 exchange is a simultaneous swap of one property for another, but many people use deferred exchanges, which allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.
To qualify as a Section 1031 exchange, a deferred exchange cannot be simply selling one property and using the proceeds to purchase another property (which is a taxable transaction).
Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property, per the IRS.
Due to their complexity, sellers usually use attorneys to facilitate exchange agreements.
The IRS further explains that both the relinquished property you sell and the replacement property you buy must meet certain requirements.
Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.
Both properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character or class. Quality or grade does not matter.
Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land.
If not a simultaneous swap of properties, you must meet two time limits to defer or the entire gain will be taxable.
The first limit is to identify potential replacement properties within 45 days from the date you sell the relinquished property. The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.
— Lauren Bunting is a licensed Associate Broker with Bunting Realty, Inc. in Berlin.