Within the 45-day window, taxpayers must follow one of three identification rules. The Three-Property Rule allows identifying up to three potential properties without regard to their value. The 200% Rule permits identifying any number of properties as long like-kind exchange as their total fair market value does not exceed 200% of the relinquished property’s value.
Like-Kind Property: Definition and IRS 1031 Exchange Rules (
They will have to pay tax upon sale or disposal of the second property unless another like-kind exchange is done, in which case the tax payment will be deferred again. Residential real estate is one of the more common types of investment properties I see in portfolios. Examples include vacation rentals (Airbnb and VRBO) that are not used for personal enjoyment, your basic rental property like a single-family house, duplex, mobile home, apartment building and so on. Before you invest in these properties, make sure you do your due diligence on the potential cost of maintenance and tenant management. If you are a real estate investor, you will be happy to know that the list of qualifying properties is extensive and includes most common property types used for investment purposes.
Realized
One of the more confusing aspects of this whole process is the 1031 exchange timeline you have to perform the exchange. This one isn’t a full requirement, but it will eat at your tax deferment and essentially nullify the whole purpose of the exchange. Both properties must be used for the same purpose, which essentially means you can make a case that any two investment or business properties are like-kind. The chart “Total Tax Liability From Sale of Relinquished Property Under Proposed Rules” shows the tax consequences under the proposed changes if A sells the property outright.
Limit Personal Use
Properties acquired for immediate resale, such as “fix-and-flip” properties, are also ineligible as they are considered property held for sale. Once a like-kind exchange is completed, it must be properly reported to the Internal Revenue Service. The primary document for this purpose is IRS Form 8824, “Like-Kind Exchanges.” This form must be filed with the taxpayer’s federal income tax return for the year in which the relinquished property was sold. Failure to file this form can lead to the disqualification of the exchange and the assessment of taxes, penalties, and interest. Commercial properties, such as office buildings, retail centers, warehouses, and industrial facilities, are commonly used in 1031 exchanges.
Non-recognition is conferred on a like-kind exchange on the basis that the form of the taxpayer’s investment changes while the substance of the investment does not. In a like-kind exchange, the realized gain or loss usually never disappears; rather, the unrecognized gain or loss typically carries over into the new asset. When the new asset is sold or exchanged in a taxable transaction, the realized gain or loss from the first transaction will then be recognized. The determination of intent is based on the facts and circumstances of each case. The IRS will look at factors like the length of time the property was held and the owner’s activities related to the property. When a commercial property or investment property is sold for a gain, the investor is required to pay a capital gains tax on the profit earned.
How long it takes to get your REAL ID card in the mail from the DMV
A QI is an objective third party who will sell the taxpayer’s relinquished property, hold the proceeds, then purchase the taxpayer’s acquired property and transfer the property to the taxpayer. For a transaction to be eligible for a like-kind exchange, the properties involved must meet two fundamental criteria. First, both the property being sold (the relinquished property) and the property being acquired (the replacement property) must be held for productive use in a trade or business or for investment. This requirement is central to supporting ongoing business and investment activities. For example, let’s say a taxpayer receives like-kind property worth $12,000 and $8,000 in cash in exchange for old property with a basis of $14,000. The basis in the new property is determined by subtracting the cash received ($8,000) from the basis in the old property ($14,000) and then adding the gain recognized ($6,000).
An exchange of real property held primarily for sale still does not qualify as a like-kind exchange. The exchanged properties must be of like kind, meaning they must be of the same nature or character, even if they differ in grade or quality. For example, somebody could exchange an office building for an apartment complex or raw land for a rental property.
- Usually, when a property is bought or sold, the gain realized in the process is chargeable to capital gains tax.
- Learn how a 1031 like-kind exchange works, including key steps, eligibility factors, and important deadlines to ensure a smooth real estate transaction.
- Boot can arise in several forms, most commonly as cash or from differences in debt.
- The seller must purchase like-kind property every time they sell property in order to defer taxes for the longest time period possible.
The Exchange Timeline and Identification Requirements
- Keep in mind the ownership profits and losses can directly affect each of the investors involved.
- Make sure to consult an estate planner to make sure you are following the IRS 1031 exchange rules correctly and the right steps are put in place as there are details that can invalidate this process.
- This contract must be executed before the sale of the relinquished property.
- After a Section 1031 exchange is completed, it must be reported to the IRS on Form 8824, “Like-Kind Exchanges.” This form is filed with the taxpayer’s federal income tax return for the year in which the exchange took place.
- But it’s important to keep in mind that a 1031 exchange is a complex maneuver.
- This guide explores the key requirements for like-kind exchanges, the importance of intent, and best practices to satisfy IRS criteria.
The investor can use the like-kind exchange to sell a parcel of real estate and buy another parcel as long as the parcel they buy is similar to the parcel they sell. A like-kind exchange is authorized as a Section 1031 exchange under the Internal Revenue Code (IRC). Both the like-kind exchange and like-kind property are defined under Section 1031. The exchange type you use depends on your comfort level and real estate investment strategy.
Once a buyer is secured and a purchase agreement is signed, the QI structures the transaction. The sale proceeds are wired directly into an escrow account controlled by the QI. The investor must then provide written instructions to the intermediary, outlining their intent to complete a 1031 exchange. The QI issues an exchange agreement and a replacement property identification form, which must be completed within the IRS-mandated timeframe. A completed exchange must be reported to the IRS on Form 8824, “Like-Kind Exchanges.” This form is filed with the federal income tax return for the year the relinquished property was sold. It details the properties, transaction dates, and calculations for any recognized gain and the new property’s basis.
Investors use this strategy to upgrade to larger properties, diversify holdings, or enter new markets. An investor who owns a $2 million strip mall may exchange it for a $3 million shopping center, provided all proceeds are reinvested and debt levels are maintained to avoid taxable boot. Usually, real estate is like-kind to other real estates as long as neither parcel is for personal use. Using an exchange facility for the transaction helps ensure that a mistake is not made regarding the personal property issue. A like-kind exchange happens when an investor wants to sell real estate and avoid the capital gains tax that would normally be assessed.
What Is the Purpose of a Third-Party Intermediary in a Deferred Like-Kind Exchange?
Prior to this legislation, a variety of assets, including machinery, equipment, and even artwork, could qualify for a like-kind exchange. For exchanges completed after December 31, 2017, the provision is now limited to exchanges of real property, meaning personal property like vehicles or collectibles no longer qualifies for this tax deferral. While a 1031 exchange does not eliminate taxes on investment property gains, it delays the tax burden, which can allow you to invest in higher value properties and continue growing your equity. But it’s important to keep in mind that a 1031 exchange is a complex maneuver.
If, as part of the exchange, you also receive other (not like-kind) property or money, you must recognize a gain to the extent of the other property and money received. The “like-kind” requirement in a 1031 exchange simply means that the investor must exchange one form of real property for another. This could include transactions like selling an apartment complex to purchase a warehouse or selling a retail center to purchase an office building. Delaware Statutory Trust, or DST, investments allow owners of real estate investments to pool their capital.
