What is 1031 like kind exchange?
When you transferred a property that is either personal or real property and received another property with the same nature or character, this transaction is called section 1031 Like Kind Exchange. This allows the deferral of gain recognition and thus became the real estate investors’ favorite strategy.
Since Tax Cut and Job Acts was implemented, the only property qualified for non-recognition of gain is real property that is used for business or investment and not held primarily for sale. Real property means any structure that is permanently affixed to the land. Any non-real property no longer qualify for non-recognition of gain. Any property held for personal use also do not qualify.
What properties are considered like kind for 1031 like kind exchange?
Here’s a list of the properties you can swap to qualify for 1031 like kind exchange:
- Trade of land improved with an apartment house for land improved with a store building
- City property for farm property
- Improved property for unimproved property
- Real property improved with a residential rental house for vacant land
- Real estate owned by a taxpayer for a real estate lease that runs 30 years
1031 exchange time limit
There are only two time limits that must be met. These limits cannot be extended except for reasons of hardship or you’re in a federally declared disaster area during the expiration of the time limits. Failure to meet the time limits will result to the gain be immediately taxable.
- You have 45 days from the day you sell the property to identify the potential replacement property. This is done in writing, signed by you and sent to the owner of the replacement property or the qualified intermediary.
- You have 180 days after the day you sell the property or the due date (including extension) of the income tax for the tax year you sold the property to complete the exchange, whichever is earlier.
Read more about the time limits here.
What does non-recognition of gain mean?
Non-recognition of gain in a 1031 like kind exchange means the taxable gain is deferred. Instead of paying taxes on the gain now, IRS lets the investors pay the taxes on gain when the property was sold or disposed. Even though, the recognition is deferred, the realization of gain/loss should still be reported on the due date of the tax year of the exchange.
You must use a qualified intermediary to facilitate this exchange to qualify for non-recognition of gain. Meaning, you can’t do this by yourself. Someone qualified has to do the transaction for you to make sure it is done correctly.
To report the realization of gain, a tax form 8824 must be completed and filed with your tax return.
What is exchange expenses?
Exchange expenses are what you incurred to do the transfer. The items include brokerage commission, attorney fees, 1031 Exchange Qualified Intermediary fees and deed preparation fees.
Is the taxable gain on 1031 exchange 100% deferred?
If the transaction only involves properties without boot, then the gain is usually deferred. But when boot is involved, the gain may become partially taxable.
What is a boot?
A boot happens when one party demands to receive cash along with the property, or when the property is subject to mortgage and the other party assumed responsibility, or when an unlike-kind property was added to compensate for the lower value of the like kind property exchanged (reasons not limited to this one).
A boot is the total of money, net liabilities assumed by the taxpayer and fair market value (FMV) of any unlike-kind property along with the like kind property received.
Receiving boot makes 1031 like kind exchange partially taxable. The total amount of boot received must be reported on your return on the tax year it was received.
Here’s the formula:
boot = cash received + net liabilities assumed by the other party (liability assumed by other party - liability assumed by you) + FMV of unlike-kind property receivedThe net liabilities assumed by other party is not below zero. To illustrate the boot computation, here’s a case scenario:
Damian exchanged his office building held for business for the same property owned by Johnny. Damian's property has a cost basis of $65,000 while the FMV is $150,000. Damian had a mortgage on the property of $15,000 which Johnny assumed the responsibility of. He also incurred an exchange expense of $5,000. On the other hand, Johnny's property has a cost basis of $70,000 and the FMV is $100,000. To compensate for the lower value of the Johnny's property, he paid Damian $50,000 in cash. Johnny had no mortgage on his property.Let’s compute the boot of each party from the scenario above.
Damian's boot received is $65,000 = $50,000 (cash) + $15,000 ($15,000 - $0 | net mortgage assumed by Johnny)Johnny will have no boot received because he did not receive cash from the exchange or had Damian assume his mortgage responsibility because he had no mortgage on his property.
How to compute the realized gain in 1031 exchange?
The realized gain is the deferred taxable gain. To compute the realized gain, you must first get the amount realized. The amount realized is the total of the FMV of the property received, cash received, the liability the other party assumes less exchange expenses. Once you have the amount realized, deduct the adjusted basis of the property given up, the liability of the other party you assumed and the cash you paid to the other party.
From Damian and Johnny’s example, let’s compute their respective realized gain.
Damian's amount realized is $160,000 = $100,000 (FMV of property received) + $50,000 (cash received) + $15,000 (liabilities assumed by other party) - $5,000 (exchange expense)
Damian's realized gain is $95,000 = $160,000 (amount realized) - $65,000 (cost basis of property transferred) - 0 (cash paid to other party) - 0 (liability Damian assumed)Johnny's amount realized is $150,000 = $150,000 (FMV of property received) + 0 (cash received) + 0 (liability assumed by other party) - 0 (exchange expense)
Johnny's realized gain is $15,000 = $150,000 (amount realized) - $70,000 (cost basis of property transferred) - $50,000 (cash paid to Damian) - $15,000 (liability Johnny assumed)How to find the gain recognized?
The recognized gain is the non-deferred part of the realized gain. In order to find the gain recognized, you must compute the boot and the realized gain. The rule is that the recognized gain is either of the lesser of the boot or the realized gain. Always remember to deduct the exchange expense from either the boot or realized gain before figuring the recognized gain. From the above example, we have computed both Damian’s and Johnny’s boots and realized gains. From that, we can say that Damian’s recognized gain is $60,000 ($65,000 boot – $5,000 exchange expenses) while Johnny’s is $0. This means that Damian will have to report the $60,000 of his $95,000 realized gain as taxable gain and must be included in his tax return filed on the due date of the tax year he received this amount.
Can I include the loss on 1031 exchange?
In the event that there is a loss realized in 1031 like kind exchange, unfortunately, it cannot be recognized. Meaning, losses cannot be claimed on the tax year the exchange took place. But you can claim the loss once you sold the property.
What will be the cost basis of the property after the 1031 exchange?
Under section 1031 exchange, the cost basis of the new property received is the same as the property relinquished plus-minus adjustments. Increase the basis by the boot paid to the other party, exchange expense paid and gains recognized from the exchange. Decrease the basis by the amount of boot received and the loss recognized on the exchange.
Let’s compute the cost basis of Damian and Johnny.
Damian's basis is $65,000 = $65,000 (cost basis of the property transferred) + $5,000 (exchange expense) + $60,000 (gain recognized) - $65,000 (boot received)Johnny's basis is $135,000 = $70,000 (cost basis of property transferred) + $65,000 (boot paid to Damian)What is the two year rule in 1031 exchange?
In the context of 1031 exchange, the two year rule pertains to an exchange involving related parties. The related parties are family members like brothers and sisters, spouse, parents, ancestors and lineal descendants. It doesn’t just end there. Members of a corporation or partners owning more than 50% of the business directly or indirectly or owners of a tax-exempt organization are also considered related parties.
The two year rule states that if the related parties entered into like kind exchange and disposed off of the property within 2 years, both parties must report all the unrecognized gain or loss from the original exchange on the due date on the year of disposition. Losses are disallowed for an exchange between related parties.
What to do if there’s unlike-kind property along with like kind property exchanged?
The deferral of gain doesn’t apply to unlike property even though it’s a part of a 1031 like kind exchange. Basically, the gain recognized from the unlike kind property is the difference between the FMV and cost basis of the unlike-kind property.
What documents should I bring my tax preparer if I’m involved in 1031 exchange?
If you’re involved in a 1031 exchange and you’ll be using a professional tax preparer, you’ll need to provide extra documents. These are:
- Close-out letter from qualified intermediary
- Relinquished property closing statement
- Replacement property closing statement
- Replacement property identification form
Summary
Using 1031 like kind exchange can be beneficial but can also be very technical. If you are not sure if you can do it on your own, it is highly recommended that you ask for a professional help. Chat, call or make an appointment with us to help file your return accurately. Read more about what we offer here and the benefits that come with using White Buffalo Tax.