The term “like-kind” is the most misunderstood aspect of a Section 1031 exchange. There is no need for it to cause confusion for investors not accustomed to handling their real estate sales as an exchange. Investors often assume a literal interpretation of the term and miss the point of the definition encompassed in the Internal Revenue Code. It simply means that if you sell real estate you must replace it with real estate to satisfy the like-kind test. It can be any kind of real estate and it can be located anywhere in the United States, however, it must be used as rental or investment property.
An investor’s sale of a large tract of land abounds with reinvestment opportunities if the transaction is facilitated by a Qualified Intermediary (QI) as a Section 1031 exchange. In an exchange, the goal is to go even or up in value from the sale of the old or Relinquished Property to the new or Replacement Property. To the extent that the value is not matched, the difference, not the entire transaction, will be subject to capital gains tax. It is possible to take cash or unlike-kind property at the closing without collapsing the tax deferment available in Section 1031. Investors have the opportunity to extract some cash and reinvest the balance of the value in a variety of new properties. For example, this can be made up of land for land or land and buildings, single family or multi-family rental property, commercial rental property, or business property used by the investor.
Strict guidelines for timing and identification of the new property must be followed to achieve full compliance with the regulations. Exchanges must be conducted in the same tax year or within 180 days, whichever comes first. If you start an exchange in December, then to take advantage of all 180 days, it is necessary to file for an extension of the tax filing due on April 15th or the exchange will be cut short by the due date of the tax return. Within 45 days of the sale of the Relinquished Property, a list of possible Replacement Property choices must be delivered to the QI. This is the most restrictive aspect of 1031 so knowing what you want before you sell will produce the best results.
Three rules guide the identification of the new property. The most commonly used rule is the Three-Property Rule. It allows the investor to list three properties of any value and acquire any one, two or three of the properties identified. The 200% Rule provides more flexibility for the investor to list any number of properties as long as the value of the listed properties does not exceed twice the value of the old or Relinquished Property. The third rule is called the 95% Rule and removes the restriction for the number or value of the properties listed as long as 95% of the identified properties are acquired. This rule is rarely used because of the risk involved in tainting the exchange if one property fails to be acquired.
It is important to know that the legal ownership or title of the Relinquished Property must be the same for the Replacement Property. The IRS is always tracking the tax identification number of taxpayers and any change in the ownership will result in a red flag and an unnecessary tax liability.
Land is a solid, practical, easy to understand investment vehicle. The use of Section 1031 will preserve equity and long-term wealth building even if you decide to diversify the type of real property held.
Tags: 180 Days, 45 Days, Identification Rules, Land, Qualified Intermediary, Real Estate Exchange