The Evolution of 1031 Like-Kind Exchanges
Like a well-worn hammer in the hands of a carpenter, 1031 exchanges (like-kind exchanges) have been a tried-and-true tool of real estate professionals for years. The first like-kind exchanges were authorized as part of The Revenue Act of 1921, just three short years after the first income tax code was adopted by the U.S. Congress. In the nearly 100 years since, like-kind exchanges have been removed, re-introduced, and reimagined.
In 2017, Congress agreed to give these grizzled transactions yet another face lift. The Tax Cuts and Jobs Act of 2017 (TCJA) narrowed the property types that were eligible for 1031 exchanges. Post-TCJA real property became the sole property type eligible for investors trying to avoid gains on the sale of assets via like-kind exchanges. On its face, the change seemed simple, albeit unfavorable. Quickly though, tax practitioners and real estate investors began to have some alarming concerns about the applicability of these new rules.
When a building is purchased, technically a buyer is purchasing several different assets that are combined to create a usable space. For example, an apartment complex is made up of land, a building structure, and personal property, among other assets. While this isn’t a foreign concept to many veteran real estate investors who are well-versed in the benefits of cost segregation studies, many began to question if apartment complexes, office buildings, or industrial spaces were still going to be eligible for like-kind exchanges. Inherent in each of these buildings is an element of personal property that, according to the TCJA, was no longer eligible for like-kind exchanges.
Luckily, clarification was not too far off. In proposed regulations issued in mid-2020 and confirmed in final regulations issued in late-2020, the IRS provided a much-needed safe harbor to ease investor and practitioner concerns. Essentially, the safe harbor permits replacement property to be purchased even if personal property is included, so long as the personal property does not exceed 15% of the value of the real property. Another important qualification is that the personal property must typically be transferred together with the real property.
Practitioners have varied on how best to apply this safe harbor. Some practitioners have suggested purchasing the personal property separate from the real property is the best method. Others argue that mentioning the value of the personal property in the purchasing agreement should suffice.
The good news is that irrespective of these differing safe harbor applications, like-kind exchanges can continue in much the same manner they have for several years – with some important changes. One such change is that personal property is considered good replacement property based on the safe harbor discussed above; however, that does not mean the changes introduced from TCJA should be ignored. To the extent that realized gain (gain before considering 1031 implications) is allocated to personal property, that gain must still be recognized as taxable.
Though like-kind exchanges may have earned a few battle scars – especially through the TCJA – these tax-deferral mainstays are still an important tool in the real estate world and will be for years to come.
*Due to the evolving nature of like-kind exchanges, it is important to speak with a tax advisor prior to completion, during the process, and after the completion of an exchange. Contact us today to learn more.
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