What are the rules for the 1031 exchange in 2022?

According to 26 U.S. Code § 1031, a like-kind exchange (also called 1031 exchanges) is when you exchange real property used for business or held as an investment solely for other business or investment property that is of the same type (or “like-kind”) in a single transaction. 

Essentially, that means that instead of selling a property for capital, you trade it in exchange for another qualifying property. Generally, when you make a like-kind exchange, you can defer recognizing any gains or losses on your tax returns until you sell or dispose of the property received.

Using like-kind exchanges intelligently and strategically can be very helpful in scaling and optimizing your portfolio. However, it’s crucial to understand how to set yourself up for success. 

The rules of like-kind exchanges are mandatory. As such, there are a couple of things to keep in mind. For example:

  • A taxpayer who sells and buys similar property in two mutually dependent transactions may have to treat the sale and purchase as a single nontaxable exchange unless the transactions are structured to avoid the like-kind exchange rules. This consideration may be relevant in handling a passive property that has accumulated passive activity losses.
  • If, as part of the like-kind transaction, you also receive other non-qualifying property or money, you will incur tax liability on those gains. 
  • To be a like-kind transaction, both the property traded and property received must each qualify as like-kind properties. (More on qualifications below.)
  • Time is of the essence: You must use the proceeds from the sale to purchase the other asset within 180 days of the sale of the first asset; you must also identify the property you are receiving in the like-kind exchange within 45 days of the sale. 
  • There are limitations on the amount of capital gains tax that you can defer, so be sure to research the latest tax rules before you go forward with the transaction.

What are some examples of like-kind exchanges?

First and fundamental: To qualify for a like-kind exchange, the properties being traded and received must both be business or investment properties and cannot be personal residences. Both the real property given up and the real property received must be held for productive use in your trade or business, or investment purposes. 

Properties are like-kind if they are of the same nature or character, even if they differ in grade or quality. 

Real property generally includes property classified under state and local law as real property. Real property also includes, but is not limited to, land and improvements to land, inherently permanent structures affixed to real property, structural components, and natural products.

Real properties generally are of a like kind, regardless of whether they are improved or unimproved. For example, an apartment building would be like-kind to a shopping center. 

Here are some other examples of like-kind exchanges:

  • City property for farm property.
  • Improved property for unimproved property. 
  • Real estate owned for a real estate lease that runs 30 years or longer.
  • Remainder interest in real estate for a remainder interest in another real estate, if the nature or character of the two property interests is the same.

What type of property does not qualify for a 1031 exchange?

Before the passage of 2017’s Tax Cuts and Jobs Act (TCJA), the IRS defined like-kind exchanges more broadly. For example, the transaction could have included exchanging one business for another or one piece of tangible property for another, such as artwork, equipment, machinery, vehicles, or patents. Even intangibles, like patents or other intellectual property, could have qualified for a like-kind exchange. 

That is no longer the case. As of January 2018, Section 1031 now only applies to the exchanges of real properties such as those mentioned above. 

Furthermore, there are specific types of property that are not eligible for like-kind exchange: 

  • Stock in trade or other property held primarily for sale
  • Stock, bonds, or notes
  • Other securities or evidences of indebtedness or interest
  • Interests in a partnership
  • Certificates of trust or beneficial interests
  • Choses in action
  • Foreign real property for U.S. real property

It is worth noting that the TCJA does contain a transitional rule that grandfathers in the exchange of personal or intangible property if the taxpayer disposed of the exchanged property on or before December 31, 2017, or received replacement property on or before that date. Additionally, certain exchanges of mutual ditch, reservoir, or irrigation stock are still eligible for non-recognition of gain or loss as like-kind exchanges. 

How do you report a like-kind exchange?

To report your 1031 transaction, you will use Form 8824, Like-Kind Exchanges

The form will help you determine the amount of gain deferred due to the exchange. Part III of the form will also compute the amount of growth required to be reported on the tax return in the current tax year if cash or property that isn’t of a like kind is involved in the transaction. Finally, the basis of the like-kind property received is figured on Form 8824, as well. 

If you transferred the property to another party in a like-kind exchange during the current tax year, you must file Form 8824 with your tax return for that year. Additionally, file the form for the two years following the year of a related party exchange. 

If you make more than one like-kind exchange, you can file a summary on one form and attach your statement with all the requested information for each exchange. Be sure to include your name and identifying number at the top of each page of the statement. On the summary Form 8824, enter only your name and identifying number, “Summary” on Line 1, the total recognized gain from all exchanges on Line 23, and the total basis of all like-kind property received on Line 25. 

The Bottom Line

Suppose you are ready to dispose of a property asset that you have used for business or held as a real estate investment. In that case, you may want to consider a like-kind exchange to defer your capital gains tax liability.

However, like any tax strategy, this approach has pros and cons and using it blindly without knowledge and a thoughtful game plan can backfire. If you are unsure whether a like-kind exchange is the best choice for you, seek the advice of tax professionals (like us).

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