If your business owns one building, but you want to replace it with another building, what should you do? You could sell the building, recognizing and paying tax on any gain, and then buy a new building. Alternatively, you could defer the gain by exchanging the old building for a new one in what is known as a like-kind (or Section 1031) exchange. In this blog, we’ll look at how that process works. First, it should be noted that there are strict rules that must be followed to complete the exchange, so you should consult with your CPA before beginning a transaction of this sort.
A like-kind exchange occurs when a taxpayer gives up real property that is held for productive use in a trade or business or for investment, and in exchange receives similar real property that is also to be held for business or investment use. Section 1031 of the Internal Revenue Code applies when exchanging one piece of real property for another in this way. Gain or loss on the transaction is generally not recognized immediately; rather, it is deferred until the new property is sold.
There are some exceptions to this rule. For instance, if the real property in question is held primarily for sale, gain or loss is recognized as usual. In addition, real property located outside of the US does not qualify as like-kind property with respect to real property located in the US.
A version of the rule applies when not all of the property received is of like kind – that is, when money or personal property is received in addition to real property. In this case, the recipient recognizes a gain to the extent of the fair market value of this other property, with the rest of the gain deferred.
After participating in a like-kind exchange, a taxpayer’s basis in the new property that was received is the same as their basis in the property that was given up. If non-like-kind property was also exchanged, the new basis is decreased by the amount of money received and increased by the amount of gain or decreased by the amount of loss recognized.
Section 1031 used to apply more broadly: gain and loss were also deferred on exchanges of like-kind personal property. The Tax Cuts and Jobs Act of 2017 limited the application of these rules, and now they only apply to exchanges of real property.
In December 2020, the IRS issued new regulations clarifying the definition of real property for these purposes. If property is classified as real property under state law where it is located, then it qualifies as real property for federal purposes as well. The new regulations also clarified that buildings, other inherently permanent structures, and their structural components qualify as real property. Intangible assets that represent interests in real property, such as licenses and permits to use or occupy land, are also included under the definition and are eligible for the deferral of gain or loss.
If you have any questions about like-kind exchanges, please reach out to your personal Sciarabba Walker contact or email us at info@swcllp.com.
By Miriam Nussbaum