By Charles R. Kennedy, CPA, MBA Vice President & Director of Tax Services
With commercial and residential property values rising rapidly, 1031 like-kind exchanges are becoming more attractive to certain taxpayers who are selling real property that has experienced significant appreciation in value. Like-kind exchanges—so named for Internal Revenue Code Section 1031—enable taxpayers to defer paying capital gains taxes on property they have sold, as long as they reinvest the profits from the sale into a similar property within a certain timeframe. Both properties must be used for investment, trade or business, so this tax strategy does not benefit homeowners who are buying and selling primary residences. However, residential property that is purchased for use as a rental does qualify for 1031 exchange treatment. In effect, 1031 like-kind exchanges help taxpayers preserve capital and reinvest it in properties that are more aligned with their changing investment goals.
Rising property values
Today’s rapidly rising values on commercial and investment properties can complicate the calculation of benefits of a 1031 exchange because the list prices of exchanged property may be equally high. But the key to identifying good opportunities is understanding which types of property in your market are lagging in value as others are rising. For instance, residential property may be soaring in value but warehouse space may be lagging, creating opportunity for taxpayers who want to maximize their new investment.
A little history
The concept of a tax-deferred property exchange was created in 1921 to encourage Americans to reinvest at a time when the country was still recovering from the economic and social effects of WWI. In the century since, the exchange mechanism has been expanded and contracted many times, most recently by the Tax Cuts and Jobs Act of 2017. The TCJA restricted the applicability of the 1031 exchange by repealing the ability for taxpayers to exchange personal property. Before TCJA, taxpayers could exchange commercial vehicles, aircraft and heavy equipment, among other things, to benefit from 1031 treatment. Under TCJA, only real property is eligible.
How a 1031 exchange works
The mechanics of a 1031 exchange are detailed and must be followed for the exchange to be appropriate in the eyes of the IRS: Taxpayers may not carry out a 1031 exchange on their own. To qualify for 1031 treatment, an exchange must be made through an unrelated intermediary party. “Unrelated” means the intermediary can’t be a family member or have a business relationship with the taxpayer, among other rules. When the first property is sold, the proceeds are placed in escrow by the intermediary—not the seller—to be used toward the purchase of the exchanged property. The funds must remain in escrow and under the control of the intermediary until the transaction on the second property is completed. If the seller accesses the funds at all during this period, it will trigger a tax liability. Once a second property is identified for the exchange, the intermediary facilitates the transaction. After a qualified 1031 exchange is made, the new property must be held for at least two years. A sale before that point triggers the capital gains tax liability going back to the sale of the original property. For taxpayers who are subject to large capital gains when they sell their commercial or investment property, a 1031 exchange enables them to realize the gain without recognizing it for tax purposes. The deferral of the capital gains taxes on the original property lasts as long as the replacement property is held. If you are considering selling commercial or investment property and think a 1031 like-kind exchange may be an option for you, contact your G.T. Reilly advisor.
