These days, selling real estate doesn’t seem to make anyone happy. If there’s a loss (which is more often than not the case as of late), there’s a lot of grumbling. If there’s a gain, there’s a lot of complaining about the taxes due (especially if there was significant depreciation). It all feels so black and white but there is a third option: tax deferral.
Under section 1031 of the Tax Code, there is a provision that allows you to defer tax on gain if – and it’s a big if – you participate in a qualifying like-kind exchange. It’s a pretty good deal if you can make it work. There are, however, some pretty specific requirements:
- The property to be exchanged must have been held for productive use in a trade or business or for investment (and must be exchanged for a property similarly held). Personal residences or vacation homes for personal use won’t qualify.
- The property doesn’t have to be real estate (though it typically is). It cannot be: stock in trade or other property held primarily for sale; stocks, bonds, or notes; other securities or evidences of indebtedness or interest; interests in a partnership; certificates of trust or beneficial interests; or choses in action.
- The exchange does not have to be exclusively for like-kind property. It can include like-kind property and other sources of compensation such as cash. However, to the extent that you receive property that doesn’t qualify as like-kind, you may trigger some taxable gain (in other words, you can have gain and deferral in the same year).
- The properties must be similar. Generally, that means that it needs to be of the same nature, character or class (real estate to real estate, for example). The rules for personal property exchange are a bit more restrictive (my favorite example of this is that livestock of different sexes are not property of a like-kind).
- The property to be exchanged must be clearly identified within 45 days from the date you sell the original property.
- The deal must be completed (meaning you have to be in control of the replacement property) no later than 180 days after the earlier of the original sale or the due date of the income tax return for the tax year in which the original property was sold.
Some tricky rules and restrictions apply, especially when it comes to basis. Since gain is deferred, you need to keep excellent records. Remember, you’re deferring gain (not eliminating it) so you’ll need to keep track of your basis in the replacement property after the exchange. The basis will be adjusted by any gain you might have realized, as well as any cash or other non like-kind property exchanged for the property. When you sell the replacement property, you will realize the original gain plus any additional gain on the replacement property.
There are other limitations, as well. If you don’t follow the rules, you can lose the deferral option and get zinged with penalties and interest. It’s not a terribly simple transaction in most cases and should not to be entered into without some planning and/or guidance.
And this is the part where I sound self-serving… If you’re going to seek out guidance here, find a tax professional. Don’t rely on a salesperson. At the end of the day, a salesperson may have reasons for pushing through a transaction that might not be in your best interest. Some folks also promote these schemes to be a bit misleading – you’ll see the transactions pitched as “tax free” exchanges, for example, but by now you know they’re tax deferred, not tax free, right?
To report the exchange to the IRS, you’ll file federal form 8824, Like-Kind Exchanges together with your federal income tax return in the year of the exchange (for example, if the exchange was on June 14, 2010, you’ll file the form together with your 2010 tax return due by April 18, 2011). The form is fairly straightforward but figuring out the basis and other reporting requirements may cause you to scratch your head a bit; I highly recommend a paid preparer or other tax professional to assist you with the return.
The bottom line is that a section 1031 exchange can be a great tax deferral strategy but it’s not for the faint of heart. The rules and limitations make it a bit challenging to navigate – one false move and you can trip up the whole transaction. This area can be so sophisticated that there are tax pros who devote their entire careers to section 1031 exchanges (yes, I’m stifling my yawns, too, but they really know their stuff). Even if you’re not looking to exchange a building with Donald Trump, you likely could use a little help.