Tax-Free Trades: Simple Concept, Sticky Rules
Clevenger, Novella Noland, Wymore, Cynthia, The National Public Accountant
Considerable investor interest has been shown recently in deferred "like-kind" exchanges of real estate in order to minimize tax consequences. Generally, if property currently being used in a trade or business or held for investment is sold at a gain, the gain is realized and recognized at the time of sale. Under Section 1031 of the Internal Revenue Code (IRC), however, gain may be deferred if "like-kind" property is acquired in an exchange as replacement for the property relinquished.
Those planning to take advantage of such a reinvestment strategy should be forewarned that strict adherence to the rules is demanded. The risk versus rewards should be carefully weighed before jumping.
In reviewing the tax requirements for a "deferred like-kind exchange," the reader may note an amazing similarity between the rules established by the tax laws for executing the real estate transactions and those of a good old-fashioned game of Monopoly. Being a shrewd investor places heavy importance on knowing when to buy and sell, make exchanges, mortgage property and, yes, pay income taxes. For those who have not yet had the pleasure of playing the "Deferred Like-Kind Exchange Game," an overview of Section 1031 is now in order.
Overview--IRC Section 1031
Section 1031 provides for the non-recognition of gain realized from an exchange of property held for investment or business use. The original intent of Section 1031 was to defray tax on businesses and investors alike whose main purpose was to continue their investment by acquiring similar replacement property. Thus, common nontaxable exchanges were created.
Although there are exceptions to what property may be considered for like-kind treatment (e.g., stocks, bonds, notes, choses-in-action), an exchange of property may consist of either real or personal property or some combination of both. However, only real property issues and examples will be presented here.
Under existing regulations, a gain or loss may be recognized if the taxpayer actually or constructively receives money or other property not of like kind in a transaction involving like-kind replacement. Therefore, in order to qualify for deferred exchange treatment, a taxpayer must transfer property for property, as distinguished from a transfer of property for money. The statutory requirements create a structured format within which the taxpayer must operate. Failure to comply will result in sale treatment rather than a qualifying exchange of property.
At one time the Internal Revenue Service (IRS) took the position that the transfer of property for property had to be simultaneous in order to meet the code requirements of Section 1031. In the famous case of T.J. Starker, the notion of delayed exchange was presented and affirmed by the Ninth Circuit Court of Appeals. This decision, while broadening the scope of Section 1031, left tremendous uncertainty as well. Attempts were made in the Tax Reform Act of 1984 to provide clearer guidelines with respect to deferred exchanges. Most recently, final regulations have been promulgated in the hopes of achieving a higher degree of certainty in transactions involving delayed exchanges.
Identification and Exchange Periods
A deferred exchange must be completed within two key dates. The first date falls at the end of the identification period. This period begins when the property relinquished in the exchange has been transferred, and ends 45 days later. During this period, property must be identified in writing, with this signed document being delivered to a person involved in the exchange other than the taxpayer or related party.(1)
The second key date falls at the end of the exchange period. Like the identification period, the exchange period begins on the date the property relinquished in the exchange is transferred, but ends at the earlier of either 1) 180 days later, or 2) the due date, including extensions, of the taxpayer's tax return for the tax year in which the transfer occurred. …