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Like Kind Exchange Rules Powerful But Tricky

link kind exchange

The Section 1031 like kind exchange rules complicate decisions for real estate investors. But the rules offer real estate investors opportunities for big tax savings.

This blog post, accordingly, briefly discusses how the like-kind exchange rules work. The post also highlights some issues that investors want to think about before entering into a like kind exchange contract.

Sec. 1031 Like-Kind Exchange Rules Boiled Down

Real estate investors save money with Section 1031 like-kind exchanges temporarily.

How? They allow an investor to defer the gain on the sale of appreciated investment property by exchanging that property for a similar property (and sometimes boot).  Boot is usually cash or sometimes the other party will assume the liability attached to your property.

An Example Sec. 1031 Like-Kind Exchange

Suppose you own a rental property in Washington with a basis of $250,000 and a market value of $600,000.  You might sell the house for $600,000, book a $350,000 gain on the sale, and then pay income tax on that gain.

But what if you plan to sell the home and purchase a $600,000 condo in Florida to use as a rental?  Maybe someday you plan to retire there.  Instead of selling the Washington rental outright and triggering income tax, you can do a like kind exchange for a Florida condo and save taxes on the $350,000 gain.  That saves you $70,000 in tax savings at a 20% capital gains tax rate.  This sounds attractive.

The  basic rule you need to follow to do this? The property you exchange, or relinquish, must be used in a trade or business or held for investment. (The property cannot, for example, be your primary residence.) Similarly, the property received must be used in a trade or business or held for investment.

The First Part of Safe Harbor You Want To Know

The IRS has a two-part safe-harbor test that specifies how “business-y” or “investment-y” the relinquished property and the replacement property need to be.

The first part of the safe harbor applies to the relinquished property. It says the relinquished property qualifies if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the “qualifying use period”); and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period
that the dwelling unit is rented at a fair rental.
For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).

The Second Part of Safe Harbor You Want To Know

A similar rule applies for the replacement property. The second part of safe harbor says the replacement property qualifies if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and
(b) Within the qualifying use period, in each of the two 12-month periods immediately after the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period
that the dwelling unit is rented at a fair rental.
For this purpose, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.

If you don’t meet the safe-harbor test you can blow up the like kind exchange and trigger capital gains tax.

Personal Property Incidental To the Real Property

Tax law allows taxpayers to use like kind exchanges only for real property.  But it is likely the replacement property you will be receiving includes incidental personal property as well.  Appliances and fixtures, for example, count as personal property.

You are required to recognize gain in a like kind exchange when you receive personal property, or boot, as it is often called.  This obviously complicates the like kind exchange transaction.   To determine gain recognition, personal property and real property need to be valued separately.

Fortunately, the proposed regulations for Section 1031 give taxpayers some wiggle room. Incidental personal property including appliances, heating systems, water heaters, flooring, and fixtures qualify for like kind exchange gain deferral as long as it doesn’t exceed 15% of the aggregate fair market value of the replacement property.

Note: The proposed regulations also clarify that inherently permanent structures, machinery that serves the inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of the space, and structural components that are integrated into the inherently permanent structure can all be classified as real property.

Affected taxpayers will want to carefully consider the proposed regulations and watch for the final regulations that replace them.

The Passive Activity Loss Dilemma

Many (most?) rental real estate owners are not considered real estate professionals.  Losses on rental real estate from non-professionals can only offset other passive income.  The unused passive losses accumulate over time.  The unused passive losses get released and offset ordinary income when the property is sold.

The dilemma?  If the property gets like kind exchanged, the passive losses carry over to the new property.  The new property traps the passive losses.

Lets go back to the original example. Assume $150,000 of passive losses have accumulated over the years due to mortgage interest, real estate taxes, management fees and so on.   The $150,000 of passive losses offsets ordinary income. This equates to a tax savings of $55,500 ($150,000 x 37%) in our example.

The total tax savings of the like kind exchange is really only $14,500 ($75,000-$55,500).

The big question: Is it better to take the passive losses now to help offset the taxable gain?  Or is it more advantageous to defer the losses and the gains entirely using a like kind exchange?

The Depreciation Predicament

Qualifying real estate professionals deduct real estate losses against other ordinary income. They are not limited to the passive loss rules.  The magic of rental real estate for qualifying real estate professionals is its ability to generate positive cash flow and ordinary losses in the same tax year.  And this occurs because of depreciation deductions.

Depreciation deductions taken on personal property do not qualify for like kind exchange treatment.  If $20,000 of appliances were depreciated?  That $20,000 will be recaptured at ordinary income tax rates in the exchange.

Savvy real estate investors sometimes have a cost segregation done when they purchase a rental property.  This accelerates depreciation deductions.  Usually an engineer will go through the home, separate the personal property from the real property, and provide a report detailing which assets qualify for accelerated depreciation.  This can result in immediate depreciation deductions on personal property of 15-20% of the home value in the first year.

An Example Showing Depreciation

We have the same $250,000 home and had a cost segregation performed the first year.  This results in $50,000 ($250,000 x 20%) of depreciation deductions in the first 5 years.  We also depreciated $20,000 of appliances.   Now we have $70,000 of depreciation recapture taxed at ordinary rates.  That is $25,900 of tax at a 37% ordinary tax rate.

By the way, if you never accelerate the depreciation (and depreciate the entire property using 27.5 year MACRS) you would not have any ordinary income recapture and would defer the entire gain in a like kind exchange.

Maybe you don’t want to accelerate the depreciation if you think you might like kind exchange the property someday.   With careful planning you could retire in the house, pass it to your heirs, and never realize and pay tax on the deferred gain.

Expensive Like Kind Exchange Costs

The third speed bump I want to discuss is the cost of doing a like kind exchange.

The usual selling costs such as broker fees, title fees, recording fees etc. still apply.  Let’s assume these equal 6% on the $600,000 home, for a total of $36,000.

If you sold the home outright, the gain drops from $350,000 to $314,000 because you deduct the selling fees.  At a 20% tax rate, that saves $7,200.  Alternatively, those fees are added to the basis of the new property in a like kind exchange i.e. no current tax benefit.

Intermediaries facilitate most like kind exchanges. They provide the necessary paper work and ensure the exchange meets the standards of the IRS’s 1031 tax code.  This will probably add another $2,000 or so to the cost of the exchange.

It’s also likely you will need the help of a CPA to carefully calculate the cost basis and deferred gains and file the appropriate forms with the IRS.  This can easily add another $1,000 or more to the cost of a tax return.

So consider the costs.

Closing Thoughts

The like kind exchange rules provide some interesting opportunities for investors. Especially if they are already looking to invest in other real estate.  There are some moving pieces to consider, however.  As a prudent investor, you want to crunch the numbers and see what makes financial sense.

Other Blog Posts you Might Find Relevant:

When 1031 Like-Kind Exchanges Don’t Make Sense

The Section 199A Section 1031 Conundrum

 

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