The Internal Revenue Service (IRS) has issued final regulations relating to section 1031 like-kind exchanges.
1031 Like-Kind Requirements
We call them 1031 like-kind exchanges because the rules are found at section 1031 of the Tax Code (clever, I know). The provision allows you to defer tax on gain if – and it’s a big if – you participate in a qualifying like-kind exchange that meets 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 (but see below changes under the TCJA).
- 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 to basis and other limitations. You can find out more here.
Changes Under The TCJA
The rules have been settled for awhile, but the Tax Cuts and Jobs Act (TCJA) limited like-kind exchange treatment to exchanges of real property.
Specifically, as of January 1, 2018, exchanges of personal or intangible property such as vehicles, artwork, collectibles, patents, and other intellectual property generally do not qualify as tax-deferred like-kind exchanges. Also, like-kind exchange treatment applies only to exchanges of real property held for use in a trade or business or for investment. That means that exchange of real property held primarily for sale (common in real estate heavy businesses) does not qualify as a like-kind exchange.
IRS 2020 Final Regulations
Under the final regulations, real property includes land and generally anything permanently built on or attached to land. That would include, for example, permanently affixed items such as gas lines, cooling units, and piping (without regard to whether those items comprise part of an income-generating structure). The rule is that machinery and equipment will be characterized as real property if they comprise an inherently permanent structure, a structural component, or are real property under the State or local law test.
It also generally means property that is characterized as real property under applicable state or local law. An example in the regulations included “shares in a mutual ditch, reservoir, or irrigation company described in section 501(c)(12)(A) [of the Code]if at the time of the exchange such shares have been recognized by the highest court or statute of the State in which the company is organized as constituting or representing real property or an interest in real property.” That language was originally included in a Conference Report and the premise – to include property characterized as real property under state and local law – incorporated into the regulations.
And, now, certain intangible property related to real property, such as leaseholds or easements, qualifies as real property under section 1031.
Form 8824, Like-Kind Exchanges
As before, to report a like-kind exchange, taxpayers must file Form 8824, Like-Kind Exchanges, with your tax return for the year you transfer property as part of a like-kind exchange. The final regulations do not change the due date or reporting information.
You can download the final regulations here.