Like-kind exchanges are an excellent way to defer capital gains and maximize your wealth. It allows investors to exchange real property in active usage either for business or investment purposes against a similar like-kind property and, in turn, delay paying state and federal taxes to IRS.
In the past 1031 Exchanges allowed a variety of options in terms of a like-kind replacement property. However, due to the increasing number of tax frauds, IRS streamlined this process.
Effective January 1, 2018, exchanges of equipment, machinery, vehicles, collectibles, artwork, patents, and other intellectual property and intangible business assets were barred as options for like-kind exchanges. However, certain exchanges of irrigation stock, mutual ditch, or reservoir are still suitable for non-recognition of gain or loss as like-kind exchanges.
Like-Kind Property
Properties that are similar in nature and character are considered like-kind for a 1031 Exchange, even if they differ in grade or quality.
There are a few necessary restrictions around like-kind properties that an investor needs to keep in mind before deciding a replacement property.
- Primary residences will not be viewed as an investment property for a 1031 Exchange.
- Any property purchased or sold with the purpose of a “fix and flip” is not suitable for a 1031 exchange.
- The like-kind property needs to be located within the United States. For example, a seller cannot use the proceeds from selling a property in the U.S. to buy a property in Australia and expect to defer capital gains on the sale.
- Stocks, Partnership interests, securities, and other financial assets are omitted from the definition of like-kind property.
Qualified Intermediary
A Qualified Intermediary (QI), also referred to as an Accommodator or Facilitator, assists investors with error-free Internal Revenue Code Section 1031 tax-deferred exchanges. Almost every successful 1031 Exchange requires a QI.
Can’t Touch the Cash
A QI must handle any proceeds after the sale of the relinquished property. If investors access funds in any manner, they are putting their exchange at risk.
45-Day Identification Period
The IRS rules allows an exchanger 45-days from the date of the sale of the relinquished property to identify suitable like-kind replacement property(ies).
Three sub-rules apply to replacement property identification:
- Three property Rule
According to the three property rule, an exchanger can identify up to 3 potential replacement properties irrespective of the value.
- 200% Rule
As per the 200% rule, an exchanger can identify more than three prospective replacement properties till the time the combined value of all three properties does not exceed 200% of the sale price of the relinquished property.
- 95% Rule
The 95% rule permits the exchanger to identify any number of properties with no reference to the sale price of the relinquished property if the investor closes on 95% of the value identified.
Same Taxpayer
For a successful 1031 Exchange, the buyer of the replacement property should be the same legal entity as the seller of the relinquished property.
Purchase Price
To defer all capital gains tax, the price of the replacement property (ies) must be equal to or higher than the cost of the relinquished property.
Debt Matters
The mortgage amount on the Replacement Property(ies) must equal or exceed the mortgage paid off at the sale of the Relinquished Property.
Must Report the Exchange
Most importantly, an exchanger must accurately complete IRS form 8824 (“Like-Kind Exchanges”) and add it as part of their tax return in the year in which the relinquished property was sold.
Bottomline
1031 Exchange allows tax deferral and maximizes your profits. However, the exchange guidelines need to be followed thoroughly to ensure that the IRS does not disqualify your transaction.
We have more than 15 years of experience in handling highly profitable exchanges for our varied client base. For consultation and assistance regarding 1031 exchange call – 888-395-0046 or email us at info@1031property.com.
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