Practical 1031: What is an Internal Revenue Code Section 1031 Like-Kind Exchange?

Question:  What is an Internal Revenue Code Section 1031 Like-Kind Exchange?

Answer: Section 1031 of the Internal Revenue Code allows a taxpayer who owns business or investment real estate to “exchange” the real estate the taxpayer wishes to sell (the “old property”) for replacement real estate (the “new property”) in a manner that allows all or part of the otherwise taxable gain on sale of the old property to be deferred.

1031 exchanges previously applied to a broad range of business and investment assets. In 2017, Code Section 1031 was nearly repealed in its entirety, but was fortunately preserved just for business and investment real estate. 1031 exchanges do not apply to primary residences, vacation homes (except in narrow circumstances that we will be address in a subsequent Q&A) or a developer’s inventory property, among other limitation.

The term “like-kind” came into use because the case for deferral of gain was made on the basis that the taxpayer was not cashing out of an investment but was merely changing the character of the investment from one asset to another asset of like-kind. This created several interesting issues when Section 1031 applied to varied types of business assets (e.g., was a drill press of like-kind to a CNC machine?) and investment assets (e.g., was a Picasso painting of like-kind to a Picasso sculpture?). For real estate, almost all real property is of like kind to other real property. Thus, a retail shopping center can be exchanged for an industrial building. Land can be exchanged for an office building. And so on.

Originally, 1031 exchanges involved only direct “swaps” of real estate, as when taxpayer Bob transferred his office building to taxpayer Sarah (not related to Bob) in exchange for Sarah’s warehouse building. Assuming an even trade with no cash exchanging hands, both Bob and Sarah could generally defer all of the gain on the properties they transferred. The tax basis in their old properties would become the tax basis in their new properties and that gain would become taxable only if they sold their new properties without exchanging again (if Bob and Sarah were related, the gain would be triggered if either of them sold their new property within two years). If a taxpayer continued to exchange his investment property until death, all of the deferred gain could be permanently avoided due to the tax-free basis “step-up” that allows heirs to inherit appreciated assets without having to pay the decedent’s capital gains tax. Thus, the phrase we coined many years ago – “swap ‘til you drop.”

Few of these direct two-party exchanges actually occur in real life. 1031 exchanges evolved to cover three-party exchanges where taxpayer Bob sold his office building to buyer Larry, and Larry (instead of paying Bob cash) purchased Sarah’s warehouse building and delivered it to Bob. This afforded taxpayers a measure of flexibility, but the transaction was still clumsy and required coordination for the sale and purchase to occur at the same time. Good luck.

Eventually tax regulations were promulgated that created a safe-harbor technique wherein Bob could sell his office building to Larry, sale proceeds would move from the closing escrow to a qualified exchange intermediary (a “QI”) and Bob could identify to the QI (within 45 days of sale of the old property) the warehouse property to be purchased (from Sarah). The QI would then fund the closing of the purchase of Sarah’s property for Bob. Closing must occur within 180 days of the sale of Bob’s old property. We will talk more about the safe-harbor and timing rules in a future Q&A.