Like Kind Exchanges Under IRC 1031

A. What is "like-kind"?

The like-kind exchange rules provide an exception from the general rule requiring the recognition of gain or loss on the sale or exchange of property. If the transaction qualifies, the property received in the exchange is treated as a continuation of the taxpayer's investment, and any tax that would have been owed on gain realized from the disposition is deferred.

Section 1031 only applies to property held for productive use in a trade or business or for investment. Consequently, it is not available for transfers of personal residences or "dealer" property.

The word "like-kind" refers to the nature or character of the property, and not to its grade or quality. The fact that one parcel of real property is unimproved and that the other is improved is not material since that fact relates only to the property's grade or quality, and not to its kind or class.

Examples:

1. A taxpayer who is not a dealer in real estate can exchange city real estate for a farm or ranch, can exchange a leasehold interest of 30 years or more (if that is the taxpayer's entire interest) for a fee interest in real estate, and can exchange improved real estate for unimproved real estate.
2. A taxpayer can also exchange investment property and cash for investment property of a like-kind.
3. One kind or class of property may not be exchanged for property of a different kind or class. For example, an exchange of real property (e.g. building) for personal property (e.g. a truck) does not qualify for nonrecognition treatment because the nature or character of the property is different.

B. Delayed Exchanges

A delayed exchange occurs when a taxpayer transfers property to another party in exchange for a promise by that party to transfer like-kind property to the taxpayer on some future date. This qualifies for nonrecognition treatment so long as the follow-ing two (2) conditions are met:

1. The property to be received by the taxpayer in the exchange must be identified on or before the 45th day after the taxpayer transferred his property; and
2. The identified property must actually be received by the taxpayer by the earlier of the 180th day after the taxpayer transferred his property, or the due date (including extensions) for filing the taxpayer's return for the year in which the taxpayer transferred his property.

C. Reverse Exchanges

When the taxpayers locate property before they are able to locate a buyer for the property they want to give up in a tax-free exchange, it is called a reverse exchange. The IRS established "Safe Harbors" whereby the taxpayor must park the replacement property with an exchange accommodation titleholder in a qualified exchange accommodation agreement and later identify and transfer the replacement property to the taxpayer in exchange for the relinquished property.

D. Advantages and Disadvantages of a Tax Free Exchange

1. Advantages:
   1. Will dispose of property without incurring tax especially when personal residence shelter (24 mo.) or one time over 55 exemption rules do not apply.
   2. To avoid capital gains tax rate.
   3. Installment sales are somewhat less attractive than tax free exchanges under current tax rules.
   4. To acquire a desirable property.
   5. Recent legislative attempts have attempted to limit the advantages of tax-free exchanges so investors should use it now.
2. Disadvantages:
   1. Gain on sale of rental property could be sheltered by passive losses.
   2. Gain on sale of investment property could be sheltered by unused investment interest.