Taxpayers often own a property that they would like to trade for another, but they do not want to be taxed on the exchange. Fortunately, only three years after Congress enacted the first modern income tax law, Congress added a provision that allowed taxpayers to defer gain recognition on the exchange of properties. These enormously complex §1031 rules can be distilled into one simple rule: Taxpayers can defer the recognition of gain (paying taxes) on the simultaneous or delayed exchange of one property for another.
This simple rule obscures the complexity of this law. To qualify for deferring gain recognition, the exchange must be of properties held for productive use in a trade or business or for investment. The property cannot be held for personal use. Further, stocks, bonds, inventory, and certain other properties do not qualify. The §1031 exchanged properties must be “like kind”, which means of the same nature or character even though they may differ in quality. Domestic and foreign properties are not like-kind. Though real estate is generally like kind to other real estate, even if one is improved and the other unimproved, personal property has an additional requirement to be of like class. Even when properties are like kind, there are additional hurdles before an exchange will qualify for gain deferral.
These additional hurdles include significant timing rules and rules related to taking cash out of the transaction. Originally, like kind exchanges had to be simultaneous. For example, a farmer might want to swap one pasture for one owned by an adjacent farmer. In the seminal Starker decision, the Ninth Circuit Court of Appeals expanded the concept to deferred exchanges. In a deferred exchange, a taxpayer can sell a property, deposit the proceeds with a qualified intermediary, and identify a replacement property within 45 days that is then acquired within 180 days. This concept was further enlarged to include a reverse like-kind exchange where the replacement property is acquired before the original property is sold, and a build-to-suit like kind exchange where the replacement property is improved and the improvements count as part of the replacement. Even with these substantially liberalized rules, taxpayers can still recognize gain in an exchange.
Recognizing gain on an exchange is called receiving boot. “Boot” is cash received in the exchange, which is taxed at normal capital gains rates. “Boot” also includes situations where the liabilities assumed by the buyer exceed those of the seller. If a taxpayer continually trades up, that is, acquires property worth more than the relinquished property, he or she can generally avoid boot.
§1031 like kind exchanges, though complicated, are an effective strategy to defer the recognition of gain from selling properties. They require that the taxpayer remain invested in like kind property, but otherwise permit flexibility in changing asset types, (e.g. residential real estate to commercial real estate).