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Tax Planning: 1031 Exchanges

Like-kind exchanges in general

No gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if that property is exchanged solely for property of a like kind which is to be held either for productive use in a trade or business or for investment. Nonrecognition treatment doesn't apply to stock in trade or other property held primarily for sale or to certain other excluded property.

Thus, for nonrecognition treatment to apply all of the following requirements must be satisfied:

    • The transaction must in fact be an exchange;
    • The exchange must be for like-kind property;
    • Both the property transferred and the property received must be held for productive use in a trade or business or for investment;
    • The property must not be property held primarily for sale or certain other excluded property.

A transfer of property meeting the requirements described above (footnotes 1 through 2.1) may qualify as tax-free even though the taxpayer also transfers property not meeting those requirements or money. However, nonrecognition treatment does not apply to the property transferred which does not meet the above requirements.

Like-kind exchanges need not be simultaneous. Nonrecognition treatment applies to deferred like-kind exchanges if the property to be received meets the identification requirement and the exchange is completed within certain time limits.

In the case of exchanges between related persons, nonrecognition treatment under Code Sec. 1031 doesn't apply if either the property transferred or the property received is disposed of within two years after the exchange.

Multiple party exchanges may qualify for nonrecognition treatment.

A taxpayer who exchanges property in a like-kind transaction has to report the exchange, even though no gain or loss is recognized, on Form 8824. If the taxpayer has any recognized gain because he received money or unlike property (i.e., boot.) as part of the exchange, the taxpayer has to report it on Form 1040, Schedule D or Form 4797, whichever applies.

How to Structure a Like-Kind Exchange

There are two time deadlines we must meet: First, within 45 days from the date you transfer the property you now own, you must identify in writing the replacement property you wish to acquire. Second, you must receive this property within 180 days from the date you transfer the property or by the due date for your tax return (including extensions), whichever is earlier.

You must be using the property you plan to relinquish for productive use in a trade or business or investment. Similarly, you must intend to use the property you acquire for one of these two purposes. Also, the property you relinquish and the property you receive must be of like-kind. This means that the nature and general character of the properties must be similar. Thus, you can exchange a piece of unimproved realty for improved real property.

These types of property cannot qualify for nonrecognition, even if they are of like-kind: inventory, stock, bonds or notes, other securities or indebtedness, partnership interests, certificates of trust or beneficial interests, or choses in action. If you receive any of these properties in the exchange, you will have to recognize gain equal to the fair market value thereof. However, the rest of the transaction can still qualify for like-kind treatment.

It is likely that the replacement property you wish to acquire will not be precisely equal in value to the property you relinquish. Should this occur, cash or other property may be included to equalize the exchange without causing loss of nonrecognition treatment. However, the party receiving such “boot” must recognize gain equal to the sum of cash and the fair market value of the nonqualifying property received.

Frequently, parties to an exchange are unable to transfer title on the same day. A common reason for this is that one of the replacement properties has not yet been identified. These types of exchanges are called “nonsimultaneous.” Nonsimultaneous exchanges present special challenges because the party that is able to transfer title first often wants the other party to place funds in escrow or make similar arrangements to ensure performance in accordance with the parties' agreement. If you use an escrow fund or similar arrangement, there is a danger that the IRS could treat you as having “constructively received” the funds and tax you on the full amount thereof. With proper planning, however, it is possible to avoid this result by use of several “safe harbors.”

These are some of the key issues involved in structuring a like-kind exchange. Please give me a call at your earliest convenience so that we can determine how to best utilize the safe harbors and answer any questions you might have.

Common Questions and Answers Relating to Like-Kind Exchanges

  • Question and Answer 1:
    Does a taxpayer have extra time to qualify an exchange under Code Sec. 1031 if the 45 or 180-day time period ends on a Saturday, Sunday, or holiday?
Probably not. It is unclear whether Code Sec. 7503 extensions of time apply to like-kind exchanges. To be safe, taxpayers should complete the transaction before such dates.
  • Question and Answer 2:
    Does real or personal replacement property need to be described in detail?
Yes. Real property will be deemed unambiguously described if it is described by a legal description, street address or distinguishable name. Personal property will be considered properly identified if it is described by a specific description of the particular type of property.
  • Question and Answer 3:
    Can constructive receipt be avoided in an exchange?
Yes. A taxpayer may employ a qualified trust or escrow, a security or guarantee agreement, qualified intermediary or a growth or interest factor in order to avoid constructive receipt.
  • Question and Answer 4:
    Can constructive receipt be avoided in an exchange if a safe harbor is not used?
Probably. A taxpayer may avoid constructive receipt if he uses an escrow agreement based on a qualified escrow account or relies on case law.
  • Question and Answer 5:
    Is it possible for a taxpayer to avoid like-kind treatment?
Possibly. If a taxpayer intentionally fails to meet the formalistic requirements of Code Sec. 1031 like-kind treatment may be avoided. However, if the transaction resembles a like-kind exchange in substance the transaction may be recharacterized as a like-kind exchange.
  • Question and Answer 6:
    Can a taxpayer avoid recognition of gain on the assumption of liabilities if he places a liability on the property he is relinquishing immediately before the exchange?
Yes. If the money borrowed is from an independent lender, at a market rate, and is obtained in arms length transaction gain is not recognized on the assumption of liabilities.
  • Question and Answer 7:
    If a taxpayer acquires property to be used in the exchange immediately before the exchange will the taxpayer still receive nonrecognition treatment?
No. The IRS has ruled that property acquired immediately before the exchange does not meet the “held for” requirement.
  • Question and Answer 8:
    If a taxpayer disposes of the replacement property immediately after the exchange is the taxpayer still entitled to nonrecognition treatment?
No. The immediate subsequent disposition of replacement property indicates an intent not to continue the investment.
  • Question and Answer 9:
    If a taxpayer “gifts” the replacement property to a third party following the exchange is the taxpayer still entitled to nonrecognition treatment on the exchange?
Yes. If a taxpayer demonstrates that the motivation behind the gift was not the ultimate liquidation of the property.
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