A like-kind exchange, sometimes called a 1031 exchange after the section of the Internal Revenue Code that governs these transactions, is the exchange of one business or investment property for another. Provided the property you receive is of a “like kind” to the property you transfer, and all other requirements are met, no gain or loss is recognized on the income deferred as a result of the exchange. This has made like-kind exchanges a popular technique for investors looking to defer the payment of taxes on capital gains. When it comes to like-kind exchanges, though, even the most straightforward transaction is complicated.
If there is a “basic” like-kind exchange, it takes the form of a simultaneous exchange. You transfer business or investment property to another party in return for similar property. For example, let’s say you own a piece of land that has a basis of $200,000 (your cost) and a fair market value of $400,000. If you were to sell the property, you would recognize $200,000 in gain. Instead of selling the land, however, you exchange it for a rental property owned by another individual. If all the conditions of IRC Section 1031 are met, you do not recognize any gain as a result of the exchange (recognition of any gain is deferred until you sell the rental property). If you receive cash in addition to the rental property, gain is recognized to the extent of the cash received.
With a deferred exchange, you give up your original property before receiving the replacement property. During the time that you’re looking for a replacement property, you can’t touch the proceeds from your original property (taking control of cash or proceeds before the entire like-kind exchange is complete can disqualify the transaction). For this reason, deferred like-kind exchanges generally involve executing a written exchange agreement with a qualified intermediary or other exchange facilitator, such as a bank, trust company, or attorney, that you pay to handle the transaction. The intermediary, who may assist you in locating a replacement property, is responsible for keeping the proceeds from your original property separate in an escrow account until the exchange is complete.
In a deferred exchange, you have 45 days from the date that you relinquish your original property to identify, in writing, potential replacement properties. You must then receive the replacement property and close the exchange within 180 days from the date you relinquish your original property, or by the due date of your tax return (including extensions) for the tax year in which you relinquished your original property, whichever is earlier.
Tenancy-in-common (TIC) exchanges
With a TIC exchange, you exchange real property, and as replacement property, you receive a partial ownership interest (you’re a co-owner, specifically a tenant-in-common) in commercial real estate. For example, you might exchange a piece of land with a fair market value of $400,000 for a 10% TIC ownership interest in a $4 million commercial property. TIC interest offerings include partial ownership interests in manufacturing facilities, office buildings, and malls.
These exchanges are extremely complicated. In fact, for a TIC interest to even qualify as potential replacement property in a like-kind exchange, there are extensive conditions that must be met. Most TIC interests are sold as securities, and are not available to the general public. TIC interests are generally available only to individuals who qualify as “accredited” investors (basically, those with a net worth greater than $1 million, or income of at least $200,000–$300,000 for a married couple–for the prior two years). TIC offerings are non-conventional investments, and while they might provide ownership opportunity in a larger property than you might otherwise be able to afford, they are not suitable for all investors. In addition to the significant fees and lack of liquidity generally associated with TIC exchanges, you’ll typically have little or no day-to-day control over the TIC property.
It can’t be overemphasized: like-kind exchanges are complicated, and there’s simply no way to cover all the rules here. So, before you even consider a like-kind exchange, you should familiarize yourself with the details, including all tax aspects of an exchange. Note as well that special rules apply to exchanges between related parties.
A like-kind exchange can be a powerful strategy for investors and business owners, so it’s worth understanding. But, if you’re interested, make sure that you contact a qualified professional who can help you navigate the intricate rules that apply.
Jason Gilbert is Managing Director of RGA Investment Advisors LLC. He has over 10 years of experience in investment advisory, including portfolio construction, financial strategy, and advanced planning for high-net worth and institutional clients. He maintains an extensive background in both forensic accounting and personal finance, and serves as a fiduciary and trusted partner to his long-standing clients.