General information on Like-Kind Exchanges

What is a like kind exchange?

A like-kind, or 1031, exchange is a way to postpone capital gains tax on the sale of a business or investment property by using the proceeds to buy a similar property.

What are the steps?

1. Identify the property you want to sell.  (usually a property that has increased in value, as you are going to defer the capital gains on the appreciation, the difference between your basis and the fair market value.
2. Hire a qualified intermediary to hold any sale proceeds for you.  You are not allowed to have access to the sales proceeds before the purchase of the new (“exchanged”) properties. This will nullify the Section 1031 exclusion.
3. Sell your property.  (Proceeds go to the intermediary).
4. Find the replacement property(ies).  You have 45 days to identify up to 3 replacement properties.
5. Purchase the replacement property.  You have 180 days to complete the purchase. The intermediary sends the funds to the seller of the replacement property.
6. File your 8824.

What property is eligible?

Property eligible for 1031 exchanges are generally only for business or investment properties. Property for personal use, such as your home, or a vacation house, typically doesn’t count. Securities and financial instruments, such as stocks, bonds, debt instruments, partnership interests, inventory and certificates of trust also usually aren’t eligible for 1031 exchanges, however they may be included in the deal as “boot.”  Cash can also be part of the deal, also as “boot.” 

What is boot?

Boot refers to the portion of a transaction that doesn't meet the tax-free criteria and hence becomes immediately subject to capital gains tax.  

Why is it a deferral of capital gain?

A property can go through multiple like-kind exchanges with the gains deferred until it's finally sold in the traditional manner.  When it's sold not in a 1031 transaction, the capital gain tax is due.

There are four types of like kind exchanges, mostly based on the timing of the exchange events:

1. Deferred Exchange (or delayed):  This is the most frequent type.  The buyer and seller exchange properties at different times.  Typically, the seller sells his property, starts the 45 day search, and then purchases the exchanged property within the 180 day window
2. Simultaneous Exchange: The buyer and seller exchange properties at the same time in one transaction
3. Reverse Exchange: The seller buys the new property before selling his “old” property. The title to the new property would be held by an intermediary for the 180 day window for selling the old property. The steps in a reverse exchange are different than described above, they are:
   • Purchase the replacement property.   The intermediary keeps the title of the replacement property.
   • Identify the property you want to sell.  (usually a property that has increased in value, as you are going to defer the capital gains on the appreciation, the difference between your basis and the fair market value.
   • Sell your property.  You have 180 days to complete the sale.
   • File your 8824.
4. Improvement Exchange (or construction exchange, or built-to-suit exchange): The seller uses the proceeds from the sold property to improve or build a new property as the exchanged property. 

Further explanations in calculating gain, whether deferred or not:

Realized gain is a seller's gain that he is realizing on the sale, whether it's recognized (currently taxed) or not.  Realized gain is the FMV of all properties received less the adjusted basis of all properties given. 

Example:  I sold my building, FMV 800,000, adjusted basis of 500,000 and also gave up $25,000 in cash.  So I gave up in total FMV, $825,000.   I received a building worth 950,000 in the exchange.  My realized gain is 950,000 – 525,000 = 425,000.

Recognized gain is the lesser of the a) Gain realized, or b) boot received. 

Example: I sold my building, adjusted basis of 500,000, and received a new building, FMV of 600,000 and cash in the amount of 50,000.   My realized gain is 650,000 – 500,000 = 150,000.  My recognized gain is the lesser of 150,000 or 50,000 (the boot).  So my gain to recognize and be taxed on is 50,000.

It's also possible to have a realized loss on a 1031 exchange, which will be deferred until the property is disposed of a later date.  Example: I sold my building, FMV of 500,000, adjusted basis of 300,000.   In exchange, I received a smaller building with a FMV of 200,000 and cash in the amount of 50,000.  I realize a loss of 300,000 – 250,000 = 50,000. 

Adjusted basis of new property:

There are two ways to calculate the adjusted basis of the new property received in the transaction.  

1. Basis of property received = FMV of 1031 property received + any loss deferred – any gain deferred.

In the earlier example,  I sold my building, FMV 800,000, adjusted basis of 500,000 and also gave up $25,000 in cash.  So I gave up in total FMV, $825,000.   I received a building worth 950,000 in the exchange.  My realized gain is 950,000 – 525,000 = 425,000.  This gain was deferred since my transaction qualifies for 1031.  My adjusted basis of the new property is 950,000 – 425,000 = 525,000.

Another example....

 I sold my building, adjusted basis of 500,000, and received a new building, FMV of 600,000 and cash in the amount of 50,000.   My realized gain is 650,000 – 500,000 = 150,000.  My recognized gain is the lesser of 150,000 or 50,000 (the boot).  So my gain to recognize and be taxed on is 50,000, and the 100,000 gain is deferred.  The adjusted basis of the new property then is 600,000 – 100,000 = 500,000.  On Form 8824, this is calculated on line 25.

• Basis of property received = Adjusted basis of property given up + boot paid + gain recognized – boot received – loss recognized.

I sold my building, adjusted basis of 500,000, and received a new building, FMV of 600,000 and cash in the amount of 50,000.   My realized gain is 650,000 – 500,000 = 150,000.  My recognized gain is the lesser of 150,000 or 50,000 (the boot).  So my gain to recognize and be taxed on is 50,000, and the 100,000 gain is deferred. 

Using this method, the adjusted basis of the new property then is 500,000 + 0 + 50,000 – 50,000 – 0 = 500,000.