Even if you are not a tax professional, many people have heard of a 1031 exchange or like-kind exchange. This tax deferral provision has been a permanent part of the Internal Revenue Code for a long time. Usually, if a taxpayer swaps an asset for another asset it is usually a taxable sale. However, if the exchange comes within Section 1031, then it can generate no tax or limited tax due. Essentially, a taxpayer can change their investment without, according to the IRS, cashing out or recognizing capital gain.
The investment continues to grow tax-deferred and is a significant benefit to taxpayers. The Tax Cuts and Jobs Act (TCJA) limited this tax benefit to real property exchanges starting in 2018. Also, like-kind exchange treatment applies only to exchanges of real property held for use in a trade or business or for investment and not property held primarily for sale. Tax professionals have waited for further guidance on exactly what would be included in the definition of “real property,” and on November 23, 2020, the IRS issued final regulations providing further guidance. If a taxpayer is considering a 1031 exchange in 2021, here’s a summary of things you should consider.
Certain Steps and Deadlines Remain.
Taxpayers cannot take advantage of the tax deferral benefits if they fail to follow some basic steps regarding the properties they want to exchange. In most cases, a taxpayer needs to find a qualified intermediary to handle the exchange. Unless you can find someone with the exact property you want willing to take yours in exchange, you need a third party to hold the cash after you sell and handle the purchase of replacement property. A taxpayer cannot have receipt, or even constructive receipt, of the money involved in the exchange or the Section 1031 exchange is ruined. A taxpayer then has 45 days following the sale to designate replacement property, in writing, to the intermediary. A taxpayer must then close on the new property within 180 days of the sale of the old property. The 45-day and 180-day deadlines run concurrently so it is 45 days to designate and another 135 days to close. These are calendar days so make sure you know exactly when the deadlines expire.
What is Real Property Has Changed – Maybe.
Real property includes land and generally anything permanently built on or attached to land. In general, real property also includes property that is characterized as real property under applicable State or local law. Therefore, certain state law designations will be important to the analysis and what may qualify in one state will not necessarily qualify in another, unless it meets the other conditions in the regulations. In addition, certain intangible property (e.g. leaseholds or easements) will also qualify as real property under section 1031. Certain intangible assets (e.g. stock, bonds, and notes), but not all, are specifically excluded. The final regulations include lists of specific items that qualify but, if not listed, then a list of factors is used. For “inherently permanent structures” this includes the manner the asset is affixed, time and expense to move it, damage caused to property if moved, and whether the item is designed to be moved or suggests it will remain affixed indefinitely. Affixation is a facts and circumstances test and the final regulations provide numerous examples for guidance. A taxpayer can use these examples to compare their own specific situation, or as an argument supporting satisfaction of the multi-factor test in the regulations.
Given the potentially large tax benefits involved, it is worth considering whether an exchange of a real property holding or investment makes sense. As businesses come out of the COVID pandemic, they may decide a change in their real property holdings is beneficial going forward, especially if they can have the benefits of exchanging real property without triggering taxable gain in the process.