FS-2008-18, February 2008
WASHINGTON — Whenever you sell business or investment
property and you have a gain, you generally have to pay
tax on the gain at the time of sale. IRC Section 1031
provides an exception and allows you to postpone paying
tax on the gain if you reinvest the proceeds in similar
property as part of a qualifying like-kind exchange.
Gain deferred in a like-kind exchange under IRC Section
1031 is tax-deferred, but it is not tax-free.
The exchange can include like-kind
property exclusively or it can include like-kind
property along with cash, liabilities and property that
are not like-kind. If you receive cash, relief from
debt, or property that is not like-kind, however, you
may trigger some taxable gain in the year of the
exchange. There can be both deferred and recognized gain
in the same transaction when a taxpayer exchanges for
like-kind property of lesser value.
This fact sheet, the 21st in the
Tax Gap series, provides additional guidance to
taxpayers regarding the rules and regulations governing
deferred like-kind exchanges.
Who qualifies for
the Section 1031 exchange?
Owners of investment and business
property may qualify for a Section 1031 deferral.
Individuals, C corporations, S corporations,
partnerships (general or limited), limited liability
companies, trusts and any other taxpaying entity may set
up an exchange of business or investment properties for
business or investment properties under Section 1031.
What are the
different structures of a Section 1031 Exchange?
To accomplish a Section 1031
exchange, there must be an exchange of properties. The
simplest type of Section 1031 exchange is a simultaneous
swap of one property for another.
Deferred exchanges are more
complex but allow flexibility. They allow you to
dispose of property and subsequently acquire one or more
other like-kind replacement properties.
To qualify as a Section 1031
exchange, a deferred exchange must be distinguished from
the case of a taxpayer simply selling one property and
using the proceeds to purchase another property (which
is a taxable transaction). Rather, in a deferred
exchange, the disposition of the relinquished property
and acquisition of the replacement property must be
mutually dependent parts of an integrated transaction
constituting an exchange of property. Taxpayers
engaging in deferred exchanges generally use exchange
facilitators under exchange agreements pursuant to rules
provided in the Income Tax Regulations. .
A reverse exchange is somewhat
more complex than a deferred exchange. It involves the
acquisition of replacement property through an exchange
accommodation titleholder, with whom it is parked for no
more than 180 days. During this parking period the
taxpayer disposes of its relinquished property to close
qualifies for a Like-Kind Exchange?
Both the relinquished property you
sell and the replacement property you buy must meet
Both properties must be held for
use in a trade or business or for investment. Property
used primarily for personal use, like a primary
residence or a second home or vacation home, does not
qualify for like-kind exchange treatment.
Both properties must be similar
enough to qualify as "like-kind." Like-kind property is
property of the same nature, character or class.
Quality or grade does not matter. Most real estate will
be like-kind to other real estate. For example, real
property that is improved with a residential rental
house is like-kind to vacant land. One exception for
real estate is that property within the United States is
not like-kind to property outside of the United States.
Also, improvements that are conveyed without land are
not of like kind to land.
Real property and personal
property can both qualify as exchange properties under
Section 1031; but real property can never be like-kind
to personal property. In personal property exchanges,
the rules pertaining to what qualifies as like-kind are
more restrictive than the rules pertaining to real
property. As an example, cars are not like-kind to
Finally, certain types of property
are specifically excluded from Section 1031 treatment.
Section 1031 does not apply to exchanges of:
What are the time limits to
complete a Section 1031 Deferred Like-Kind Exchange?
While a like-kind exchange does
not have to be a simultaneous swap of properties, you
must meet two time limits or the entire gain will be
taxable. These limits cannot be extended for any
circumstance or hardship except in the case of
presidentially declared disasters.
The first limit is that you have
45 days from the date you sell the relinquished property
to identify potential replacement properties. The
identification must be in writing, signed by you and
delivered to a person involved in the exchange like the
seller of the replacement property or the qualified
intermediary. However, notice to your attorney, real
estate agent, accountant or similar persons acting as
your agent is not sufficient.
Replacement properties must be
clearly described in the written identification. In the
case of real estate, this means a legal description,
street address or distinguishable name. Follow the IRS
guidelines for the maximum number and value of
properties that can be identified.
The second limit is that the
replacement property must be received and the exchange
completed no later than 180 days after the sale of the
exchanged property or the due date (with extensions) of
the income tax return for the tax year in which the
relinquished property was sold, whichever is earlier.
The replacement property received must be substantially
the same as property identified within the 45-day limit
Are there restrictions for deferred
and reverse exchanges?
It is important to know that
taking control of cash or other proceeds before the
exchange is complete may disqualify the entire
transaction from like-kind exchange treatment and make
ALL gain immediately taxable.
If cash or other proceeds that are
not like-kind property are received at the conclusion of
the exchange, the transaction will still qualify as a
like-kind exchange. Gain may be taxable, but only to
the extent of the proceeds that are not like-kind
One way to avoid premature receipt
of cash or other proceeds is to use a qualified
intermediary or other exchange facilitator to hold those
proceeds until the exchange is complete.
You can not act as your own
facilitator. In addition, your agent (including your
real estate agent or broker, investment banker or
broker, accountant, attorney, employee or anyone who has
worked for you in those capacities within the previous
two years) can not act as your facilitator.
Be careful in your selection of a
qualified intermediary as there have been recent
incidents of intermediaries declaring bankruptcy or
otherwise being unable to meet their contractual
obligations to the taxpayer. These situations have
resulted in taxpayers not meeting the strict timelines
set for a deferred or reverse exchange, thereby
disqualifying the transaction from Section 1031 deferral
of gain. The gain may be taxable in the current year
while any losses the taxpayer suffered would be
considered under separate code sections.
How do you compute the basis in the
It is critical that you and your
tax representative adjust and track basis correctly to
comply with Section 1031 regulations.
Gain is deferred, but not
forgiven, in a like-kind exchange. You must calculate
and keep track of your basis in the new property you
acquired in the exchange.
The basis of property acquired in
a Section 1031 exchange is the basis of the property
given up with some adjustments. This transfer of basis
from the relinquished to the replacement property
preserves the deferred gain for later recognition. A
collateral affect is that the resulting depreciable
basis is generally lower than what would otherwise be
available if the replacement property were acquired in a
When the replacement property is
ultimately sold (not as part of another exchange), the
original deferred gain, plus any additional gain
realized since the purchase of the replacement property,
is subject to tax.
How do you report Section 1031
Like-Kind Exchanges to the IRS?
You must report an exchange to the IRS on Form
8824, Like-Kind Exchanges and file it with your tax
return for the year in which the exchange occurred.
Form 8824 asks for:
Descriptions of the properties exchanged
Dates that properties were identified and
Any relationship between the parties to the
Value of the like-kind and other property
Gain or loss on sale of other (non-like-kind)
property given up
Cash received or paid; liabilities relieved
Adjusted basis of like-kind property given
up; realized gain
If you do not specifically follow the rules for
like-kind exchanges, you may be held liable for taxes,
penalties, and interest on your transactions.
Beware of schemes!!
Taxpayers should be wary of
individuals promoting improper use of like-kind
exchanges. Typically they are not tax professionals.
Sales pitches may encourage taxpayers to exchange
non-qualifying vacation or second homes. Many promoters
of like-kind exchanges refer to them as “tax-free”
exchanges not “tax-deferred” exchanges. Taxpayers may
also be advised to claim an exchange despite the fact
that they have taken possession of cash proceeds from
Consult a tax professional or
refer to IRS publications listed below for additional
assistance with IRC Section 1031 Like-Kind Exchanges.