What is the purpose of a Like-Kind Exchange? Can they go wrong and if so, what are the consequences?
Businesses and individuals complete Section 1031 Like-Kind Exchanges in order to avoid an immediate normal income and/or capital gains tax payment when replacing or upgrading assets (properties). This tax deferral and profitability tool is also known as a 1031, LKE, Starker Exchange or Tax-Deferred Exchange. Below are five examples of exchangeable assets:
- Real Estate – most real estate falls under the same like-kind classification. An Exchanger may sell a vacant lot and purchase a warehouse or apartment complex. Selling multiple rental properties and purchasing a single commercial property qualifies as well.
- Equipment & Heavy Machinery – these items often qualify under a like-purpose determination even if they’re not in the same like-kind classification. Heavy equipment and “yellow iron”, used for mining, farming, construction, and oil & gas work are all eligible. Examples:
- – Sell two bulldozers and buy one scraper
- – Sell a Ballerini drilling rig and buy a Loadcraft rig
- – Sell five flatbeds and buy two flatbeds and a reefer
- Business Assets – while one business cannot be exchanged for another, each of the business’s assets may qualify.
- Build-to-Suit Exchange – this specialized 1031 exchange requires the Qualified Intermediary (QI) to hold the property via a temporary LLC while improvements are made. These improvements must occur during the normal 180-day Exchange timeline. The owner can direct exchange funds for the asset improvements and control the construction or customization. Examples:
- – Sell an office building and buy another one with planned renovations
- – Sell two cranes and buy another one requiring modifications for the Exchanger’s particular intended use
- Intangible Personal Property – although less common, intangible property is also eligible for a Like-Kind Exchange. For example, licenses for distribution and manufacturing rights can be swapped if they are very similar.
1031 Exchanges result in tax deferral, not tax avoidance. Tax on any gain remains payable, but not until the replacement property sells at some future date, without another 1031 Exchange coming into play. A “disinterested third party”, most commonly a “Qualified Intermediary”, is required by the IRS to facilitate these transactions. A typical 1031 takes the Exchanger just an hour or two to complete, perhaps with an additional 30 minutes per property transaction beyond the first.
Can a 1031 Exchange go wrong? Yes, there are several potential pitfalls with a 1031 Like-Kind Exchange. Here are a few primary areas of concern:
- Time requirements are strict and unwavering. If not met, the 1031 will be void and the transaction taxable. The Exchange must be completed within 45 days, or replacement property designated within 45 days and closed on no later than 180 days following the sale of the original property.
- Property flipping is not allowed. Generally, properties bought and sold in an Exchange must be held for a minimum of 2 years. Ignoring this 1031 rule can lead to a voided Exchange with taxes and penalties becoming immediately due. The intent of 1031 Exchange is for the taxpayer to use the Exchange for business use or investment, not to turn inventory.
- Risk of trading down. The replacement property should be of equal or greater value to the relinquished property. Otherwise, trading down results in cash received and/or debt reduction, which become a taxable gain. This is termed as “boot” and is a serious pitfall to discuss with your QI and tax professional before entering into an Exchange.
- A 1031 Like-Kind Exchange must be in place BEFORE transactions begin in order to be valid in the eyes of the IRS.
Ready to discuss a personal or business-related 1031 Exchange? Give us a call with or without your accountant and we’ll be happy to provide a no-cost, no-obligation planning approach for your transaction(s).