Property owners interested in disposing of commercial or investment real estate, and deferring the resulting taxable gains, may benefit from a Section 1031 “like-kind” exchange. Under this provision, they can exchange real property held for investment or for use in a trade or business for a similar (or like-kind) investment property.
Under tax regulations, the idea of a “like-kind” property is defined broadly. Most real property will be considered eligible for a like-kind exchange unless the relinquished property or the replacement property was held primarily for sale.
A like-kind exchange must involve commercial or investment real estate. Under the Tax Cuts and Jobs Act, tax-deferred Section 1031 treatment is no longer allowed for exchanges of personal property, such as equipment and personal property building components, completed after December 31, 2017.
Common examples of qualifying commercial or investment properties include:
- Single-family rental homes
- Multi-tenant apartment buildings
- Retail or office space
- Warehouses
- Farm or vacant land
Structuring a Like-Kind Exchange: Asset-for-Asset or Boot
For a straight asset-for-asset exchange, you won’t have to recognize any gain from the transaction, and your basis (the acquisition cost for tax purposes) transfers from the relinquished property to the replacement property. You then report the transaction on Form 8824, “Like-Kind Exchanges.”
In many transactions, however, the properties aren’t equal in value. In these instances, cash or other property is added to the deal. These additional assets are known as “boot.” If boot is involved, you’ll have to recognize a gain for tax purposes, but only up to the amount of boot you receive in the exchange.
In these situations, your basis in the like-kind replacement property becomes:
- The basis you had in the relinquished property,
- Reduced by the amount of boot you received, but
- Increased by the amount of any gain recognized.
No matter how much boot you receive in a transaction, you’ll never recognize more than your actual (or “realized”) gain on the exchange.
Debt Relief in Like-Kind Exchanges
If the property you’re exchanging is subject to debt from which you’re being relieved, that amount is treated as boot because it’s equivalent to receiving cash in the transaction. If the replacement property is also subject to debt, that amount can reduce or exceed the boot.
Estate Planning Tax Advantages
Like-kind exchanges can also play a role in estate planning because the tax basis for any beneficiaries who receive property that have been exchanged will receive it at the fair-market value on the day on which the property is inherited. This value could be significantly higher than the previous basis, allowing the beneficiaries to avoid taxes that had been deferred in previous like-kind exchanges.
If your properties meet the requirements, like-kind exchanges can be an effective tax-deferred way to dispose of investment, trade, or business real property.
For more information on 1031 exchanges read our article “1031 Exchange Rundown: What you Need to Know”.
Contact us if you have questions or would like to discuss the strategy further.
