Section 1031 of the Internal Revenue Code (the “Code”) is a provision that allows U.S. taxpayers to defer the recognition of gain on sales of certain types of assets when they are conducted through a “like-kind exchange”. Taxpayers do not avoid paying income tax on their gain, but rather defer that gain until later (usually when they dispose of the asset received in the exchange). Like-kind exchanges are complex transactions and taxpayers should only consider like-kind exchanges with the assistance of their own lawyers and tax advisors. This white paper does not provide legal advice, but does summarize many of the key considerations taxpayers should consider when evaluating the sale of an asset and the potential use of a like-kind exchange.
The ABCs of Section 1031
Like-Kind Exchanges Defined
Section 1031 allows a taxpayer (an “Exchanger”) with a qualifying asset to dispose of the property (called the “Relinquished Property”) in exchange for another property (called the “Replacement Property”) through the services of a Qualified Intermediary. There are several key requirements that apply to a like-kind exchange:
- Qualifying Property – The Relinquished Property must meet the requirements for Section 1031. In general, qualifying property must be either real property or tangible personal property that is held either for investment purposes or for productive use in a trade or business.
- Qualifying property may include: raw land or farmland, oil or gas royalties for a ranch, fee simple interest in real estate or a tenant-in-common interest in real estate, residential, commercial, industrial or retail rental properties, corporate jets, patents, and artwork.
- Qualifying property does not include: stock in trade or property held primarily for sale (i.e. properties held by a developer, “flipper” or dealer), securities or other evidences of indebtedness, stocks, bonds, or notes, interests in a partnership, foreign property, or the goodwill of a business.
- Like-Kind – The Relinquished Property must be of a ‘like-kind’ with the Replacement Property. For example, an interest in raw land may be exchanged in a like-kind exchange for an interest in improved real property, but an interest in raw land may not be exchanged in a like-kind exchange for artwork, patents or a corporate jet, as those property types are not of a like-kind with an interest in raw land.
- Qualified Intermediary – The Exchanger must enter into an Exchange Agreement with a “Qualified Intermediary” that requires the Qualified Intermediary (a) to acquire the Relinquished Property from the Exchanger and transfer it to the purchaser and (b) acquire the Replacement Property from the seller for transfer to the Exchanger.
- Pre-Sale Transfer – Before the closing of the sale of the Relinquished Property occurs, the Exchanger must assign its rights under the Relinquished Property sale contract to the Qualified Intermediary and notify the other parties to the sale contract.
- Sale Proceeds – At the closing, all net proceeds from the sale of the Relinquished Property (the “exchange funds”) must be paid directly to the Qualified Intermediary to be held in a separate account for the benefit of the Exchanger until used to purchase the Replacement Property. Two additional rules relate to the calculation of sale proceeds and the cost of the Replacement Property:
- If the Relinquished Property was encumbered with debt at the time of sale, the Replacement Property must be encumbered with at least the same amount of debt.
- To the extent that the exchange funds include cash, the purchase of the Replacement Property must require at least the same amount of cash.
- Identification of Replacement Property – Within 45 days from the date the Relinquished Property is transferred, the Exchanger must identify potential Replacement Properties. The identification must be specific, in writing, signed by the Exchanger and delivered to the Qualified Intermediary per Treas. Reg. 1.1031(k)-1(c)(2). The 45 day deadline is hard and cannot be waived or changed.
- Replacement Purchase – Before closing on the purchase of the Replacement Property, the Exchanger must assign its rights under the Replacement Property purchase contract to the Qualified Intermediary and provide notice of that assignment to the seller.
- Closing on Replacement – The Exchanger must authorize the Qualified Intermediary to pay the purchase funds directly to the seller or closing agent for the purchase of the Replacement Property and the seller will deliver title directly to the Exchanger, thereby completing the like-kind exchange.
- Timing of Replacement Closing – The purchase of the Replacement Property must be completed on or before the first to occur of (a) the 180th day after the transfer of the first Relinquished Property, or (b) the due date (including extensions) for the filing of the Exchanger’s tax returns.
The Role of the Qualified Intermediary
The Qualified Intermediary plans an important role in facilitating the like-kind exchange. It receives the purchase contract from the Exchanger for the sale of the Relinquished Property, holds the funds received from that closing, receives the purchase contract from the Exchanger for the purchase of the Replacement Property, and remits the net proceeds accordingly. While the Qualified Intermediary is not an advising professional, whose job it is to advise the Exchanger on the tax requirements of the like-kind exchange, a good Qualified Intermediary will be experienced with Section 1031 and will often have practical tips to make the process go smoothly. Perhaps the most important requirement of the Qualified Intermediary is that it have an excellent reputation for trustworthiness and reliability and that it have sufficient capitalization to ensure that the proceeds it holds in trust are never at risk. Well-established Qualified Intermediaries will usually have substantial insurance and performance bond arrangements to ensure their financial stability and reliability to act as the holder of trust funds.
Your Advising Professionals
Because like-kind exchanges are complicated transactions that can carry significant financial and tax risks, Exchangers should be sure to hire experienced legal and tax advising professionals. The Exchanger’s attorney should have experience in structuring and closing like-kind exchanges and should be involved in drafting or reviewing the applicable closing documents, including the Exchange Agreement with the Qualified Intermediary. The Exchanger’s attorney should also provide assurances to the Exchanger that the transactions will satisfy the requirements of Section 1031 for treatment as a like-kind exchange. The Exchanger’s tax advisors or accountants should also play a role in calculating the tax impacts of the transaction and ensuring that those tax impacts are appropriately taken into account for purposes of the Exchanger’s tax planning.
Other participants in the transaction, include the purchaser of the Relinquished Property, the seller of the Replacement Property, other investors (if any) and the Qualified Intermediary may also have attorneys or accountants advising on the transaction. At times, those professionals may discuss considerations that relate to ensuring that the transactions satisfy the requirements of Section 1031. While it is helpful to have such professionals involved, and while deal participants are usually aligned in their desire to ensure that Section 1031 is satisfied, their participation should not be relied upon by the Exchanger. The Exchanger can only receive legal and tax advice from the Exchanger’s own attorneys and tax advisors.
Planning and Timing
A Section 1031 like-kind exchange involves several hard deadlines. The first is that the Exchanger must identify the potential Replacement Property within 45 calendar days after the first transfer of the Relinquished Property. The second is that the Exchanger must receive the Replacement Property before the first to occur of (a) the 180th day after the transfer of the first Relinquished Property, or (b) the due date (including extensions) for the filing of the Exchanger’s tax returns. Because these deadlines cannot be waived or extended, it is very important for parties involved in a like-kind exchange to plan their transactions in advance and to utilize experienced professionals who have concluded many like-kind exchanges.
An Exchanger will often decide to use a like-kind exchange only after finding a purchaser for their Relinquished Property. That is not a problem because the Qualified Intermediary’s role at the closing of the sale of the Relinquished Property is minimal. Once the Exchanger and the Qualified Intermediary have entered into the Exchange Agreement, the Qualified Intermediary takes an assignment of the Exchanger’s sale contract for the Relinquished Property and acts on behalf of the Exchanger at the closing of the sale. Ideally, though, the Exchanger and the Qualified Intermediary would have decided to work together at least a few weeks before closing so that the Qualified Intermediary can work with the closing attorneys to ensure a smooth and trouble-free closing where the Qualified Intermediary can hold the sales proceeds (the “exchange funds”) received from the purchaser at the closing.
An Exchanger may identify a Replacement Property before the closing of the sale of the Relinquished Property, but identification often takes place after the Relinquished Property is sold. Identifying the Replacement Property is important, both because of the strict 45-day deadline but also because counsel should be involved to ensure that the Replacement Property is of a like-kind with the Relinquished Property.
Construction Exchange or Build-to-Suit Exchange
A Construction Exchange (sometimes also called a “build-to-suit” exchange) is a variation in which the Exchanger works with the QI, acting as an “Exchange Accommodation Titleholder” or “EAT” so that construction work is initiated and completed on the Replacement Property after the Replacement Property is acquired by the QI and before the Replacement Property is conveyed to the Exchanger. A Construction Exchange is an appropriate solution where the Exchanger is acquiring a Replacement Property with a purchase price that is less than the proceeds of the Relinquished Property. If the Exchanger can arrangement to have additional construction work performed on the Replacement Property in a deferred exchange during the time that the QI is holding title to the Replacement Property, then the cost of the construction work (if paid from the process of the Relinquished Property or with a construction loan obtained on the Replacement Property that is assumed by the Exchanger) can be included in the calculation of the cost of the Replacement Property to ensure full deferral of gain through the like-kind exchange.
A further variation takes place when an Exchanger identifies a Replacement Property before the Exchanger identifies the Relinquished Property. The same time periods (45 days to identify; 180 days to close) will apply in this type of like-kind exchange, except that those time periods will run from the date that the QI closes on the purchase of the Replacement Property. A Reverse Exchange is a helpful structure for situations in which an Exchanger that owns a wide portfolio of properties for business use or investment identifies a Replacement Property for purchase but needs additional time to identify which portfolio property will serve as the Relinquished Property.
Other Questions and Resources
Like-kind exchanges are appropriate vehicles for deferring taxable gain in transactions for the purchase or sale of property for business or investment. They involve complex tax and legal concepts, however, so property owners and investors should be sure to consult their own tax, accounting and legal professionals. While transaction parties often have their interests aligned, those aligned interest are not sufficient to allow a transaction party to rely on the actions or suggestions of tax, accounting or legal professionals who have not been engaged to advise them. This memorandum identifies many of the key provisions involved in like-kind exchanges, but is not an exhaustive summary of all the relevant rules or risk factors. Property owners and investors should conduct their own due diligence, with the assistance of their own professionals, when making investment and tax-planning decisions.