When you own a business or property, looking for strategic tax advantages anywhere you can find them is wise. This is especially true when it comes time to dispose of a property asset you have used for business or as a real estate investment.
The most common way to profit from owning a piece of real estate is by selling the property for more than you paid, often because the property’s value has appreciated or increased over time. Unfortunately, in the case of a traditional real estate sale, the gains you receive from the sale are subject to taxation — even if you plan on reinvesting the money into another property.
Fortunately, there is a way to cash out on a property and avoid a hefty capital gains tax bill: Section 1031, or a “like-kind exchange,” allows you to defer or postpone capital gains tax liability on the transaction.
To learn more about 1031, or like-kind exchanges, and what they mean at tax time, continue reading below.
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:
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:
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:
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.
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.
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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Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.
He is a diligent financial professional, able to manage the details and turn them into relevant business leading information. He has a strong financial background in construction, technology, consulting services and risk management. He also knows what it takes to create organizations having built teams, grown companies and designed processes for financial analysis and reporting.
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Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.
Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004. After a career of public accounting and general management, Jody knows the value of good financials. Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.
He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles. His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.
He has a particular expertise in early-stage growth companies. His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.
Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller. He has experience across industries, which gives him a deep understanding of business.
Jody graduated with a BBA in Accounting from Baruch College, he is a CPA and member of the American Institute of Certified Public Accountants and New York State Society of Certified Public Accountants.
In addition to delivering above and beyond accounting results, Jody is a member of the NYSCPA’s Emerging Tech Entrepreneurial Committee (ETEC), Private Equity and Venture Capital Committee and Family Office Committee.
He is an angel investor through the Westchester Angels, and has served as an advisor for many startup companies and as a mentor through the Founders Institute.
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