1031 Like-Kind Exchange

By Jason Watson, CPA
Posted Monday, August 5 2024

When you sell a rental property, either as an investment or as a business, you can invoke IRC Section 1031 to fully defer your capital gains tax including taxes associated with depreciation recapture, as long as you buy another similar property within 6 months. This is also called a like-kind exchange.

Do this right, and you can daisy-chain real estate investment transactions to avoid capital gains on real estate through your entire life, while enjoying the benefits of larger and larger incomes (the assumption is that you “1031” into larger investments with better cash flow, etc.). Said differently, your equity in the old property becomes the downstroke or down payment for the new property, and when leveraged correctly, you can quickly expand your buying power.

You can also view a portion of the down payment as an interest-free loan from the IRS. Huh? If you paid capital gains tax on the growth, your down payment is reduced by 15% to 23.8%. This can lower your purchasing power significantly assuming a structured purchase with equity and debt (mortgage).

Therefore, you can leverage 1031 like-kind exchanges to grow your rental property kingdom without having to pay taxes on the churn. What do we mean? If you wanted to get out of your Tesla stock position to dump money into Apple, you would pay capital gains taxes on your Tesla disposition along the way. Real estate property avoids this trap. This makes sense since real estate churn, if you will, invigorates the economy because so many players get paid within a transaction. Our tax code loves to encourage economic growth.

Let’s talk about purchasing power. By not having to pay taxes on your real estate gains, this ultimate increase in down payment can boost your purchasing power through leverage. In other words, what purchases more- $100,000 or $120,000 as a down payment?

This is overly simplified but highlights the objective. Scenario A is leveraging with a 1031 like-kind exchange while scenario B is leveraging after paying taxes along the way.

	Scenario A 1031 Exchange		Scenario B Paying Taxes
Single Family Home in 2020	350,000		350,000
Equity in 2025 (down payment + growth)	175,000		154,000
Down payment on 8-Unit in 2025	175,000		154,000
Purchasing Power @ 80% LTV	875,000		770,000
Equity in 2030 (down payment + growth)	393,750		308,000
Down payment on Commercial Property 2030	393,750		308,000
Purchasing Power @ 80% LTV	1,968,750		1,540,000

What happened here is that a real estate investor took $70,000 and purchased a single-family home in 2020. It grew in value, and the investor exchanged it for an 8-unit using the proceeds from the single-family rental property as the down payment for the next purchase. Lather. Rinse. Repeat.

We took some liberties on the growth factor, and for the “no 1031” column, we assumed a straight 20% capital gains tax rate. Your mileage might vary, but these calculations highlight the foundation of why a like-kind exchange is used.

Sidebar: Think of how much additional taxable revenue is created by encouraging real estate transactions with like-kind exchanges. Real estate commissions, title fees, inspection fees, among other triggered revenue, becomes taxable income of sorts for the IRS. Non-taxable transaction to you still generates a few tax bucks for the Treasury.

To top all this off, your heirs still get a full step up in basis upon your death under current tax law. Sounds easy, right? When’s the last time money was easy? There are some hurdles-

• Ineligible Property

• Deadlines (time) and spend (money)

• 1031 Exchange Qualified Intermediary

• Section 1245 property (cost segregation woes)

• State Issues

Ineligible Property

Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. In a like-kind exchange, both the real property you give up and the real property you receive must be held by you for investment or for productive use in your trade or business.

The rules for like-kind exchanges do not apply to exchanges of the following property-

• Real property used for personal purposes, such as your home.

• Real property held primarily for sale (think fix and flips, or home builder).

• Any personal or intangible property (but there is an exception for incidental property, keep reading).

The caveat of “investment or for productive use in your trade or business” is not super limiting. It is important, as we’ve seen in other sections of this chapter, for certain tax benefits involving passive activity loss limits.

Get a load of this- according to the IRS website, certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible for non-recognition of gain or loss as like-kind exchanges. What the heck is that? Colorado State University states, “A mutual ditch company is a private, voluntary, non-profit, fee-collecting entity. The company holds water rights, and members purchase shares in the company. Water is allocated annually by share, and shareholders pay assessments for company upkeep.” Who knew?

Can you exchange investment land for a building? Yes. But if that land was for your dream home initially, then it is unlikely eligible.

Can you exchange a U.S. property for a foreign property? No.

Can you exchange foreign property for another foreign property? Yes.

Can you exchange a property in California for one in Texas? Yes, but you have an annual California filing requirement.

Can you exchange oil and gas interests? Tenant in common interest in a real property? Yes and Yes.

Deadlines and Spend

Two definitions real quick- relinquished property is what you are selling, and replacement property is what you are buying. Rules to exchange by-

• Replacement property must be identified within 45 days.

• Replacement property must be purchased (fully closed) within 180 days.

• Replacement property should be of equal or greater value to the one being sold.

Identifying the replacement property must be handled correctly. Here is a blurb from IRS Fact Sheet 2008-18,

The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.

Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.

Woah. Look at that last sentence. There is a maximum number of properties and value? Yes, there is! IRS Publication 544 Sale and Other Dispositions of Assets reads,

You can identify more than one replacement property. However, regardless of the number of properties you give up, the maximum number of replacement properties you can identify is:

1. Three properties regardless of their fair market value; or

2. Any number of properties whose total fair market value at the end of the identification period is not more than double the total fair market value, on the date of transfer, of all properties you give up.

Fun!

1031 Exchange Qualified Intermediary

The intermediary can be a person, company, or other entity, but must not be related or married to the taxpayer. In other words, they must be professionally detached and disinterested in the transactions.

According to the IRS Fact Sheet 2008-18,

You cannot act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator.

The Fact Sheet also warns real estate investors of the possibility of the 1031 exchange qualified intermediary going bankrupt or being unable to fulfill the transaction leaving the investor non-compliant. Lovely.

Personal Property (Section 1245)

With the Tax Cuts and Jobs Act, personal property was excluded from being exchange eligible. Why do you care? With any real estate property transaction, inherently there is personal property being exchanged. Whether that is identified and valued usually depends on an existing cost segregation study of the relinquished property.

Let’s say you bought a $500,000 short-term rental and the cost segregation report came up with $80,000 in personal property eligible as 5- and 7-year property. Naturally, you accelerate depreciation of these items with bonus depreciation. Later, you enter into a 1031 like-kind exchange with another real estate investment property. Neat. However, a portion of your relinquished property is personal property, which is not eligible for tax-free exchange.

This could be a big deal, right? $80,000 in personal property associated with the rental that is fully depreciated and then later taxed at 37% marginal tax bracket upon depreciation recapture would be a $29,600 surprise tax bill. Wow, that’s a long sentence.

It is doubtful that the fair market value of the personal property would be $80,000 upon resale, but we still have a problem since there is some value. Also, land improvements, such as fences and sidewalks, or otherwise 15-year property, can be considered personal property (Section 1245) or real property (Section 1250) depending on the chosen method of depreciation.

What do you do? Historically, what rental property owners and tax professionals would do is assign ridiculously low fair market values to the personal property portion the transaction, recognize a little bit of depreciation recapture gain, and move along.

This would fail under IRS examination of course. In response, the IRS created a safe harbor of sorts that allows incidental personal property to be exchanged without this pesky depreciation recapture. Treasury Regulations Section 1.1031(k)-1(g)(7)(iii) reads-

(iii) Personal property generally resulting in gain recognition under section 1031(b) that is incidental to real property acquired in an exchange. For purposes of this paragraph (g)(7), personal property is incidental to real property acquired in an exchange if—

(A) In standard commercial transactions, the personal property is typically transferred together with the real property; and

(B) The aggregate fair market value of the property described in paragraph (g)(7)(iii)(A) of this section transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property or properties received in the exchange.

Cool. So, in using our example above, if you exchanged your rental property that is now worth $650,000 for another that has a fair market value of $800,000, you have a 15% x $800,000, or $120,000, cushion (ceiling) to the fair market value of the personal property being sold.

Another way to look at this- take the identified personal property’s fair market value in your relinquished property and divide that amount by the replacement property’s purchase price. This number needs to be 15% or less.

To recap- personal property is not eligible for a 1031 like-kind exchange unless it is considered incidental. To be incidental, it needs to be customary in a commercial transaction setting, or its fair market value needs to be 15% or less of the replacement property’s purchase price.

State Issues with 1031 Like-kind Exchanges

Every state is unique in terms of conforming to federal tax code. Let’s pick on California since it is an easy target. According to California’s instructions, in part, for 2023 California Form 3840,

In general, for taxable years beginning on or after January 1, 2015, California law conforms to the IRC as of January 1, 2015. However, there are continuing differences between California and federal law. When California conforms to federal tax law changes, we do not always adopt all of the changes made at the federal level.

The source of a gain or loss from the sale or exchange of property located in California is determined at the time the gain or loss is realized. The source of such gain or loss is preserved without regard to when such gain or loss may be recognized.

Form FTB 3840 must be filed for the taxable year of the exchange and for each subsequent taxable year, generally until the California source deferred gain or loss is recognized on a California tax return.

What does all this mean?

• California adopts federal tax code at its discretion. No kidding.

• The gain is computed when realized (time of sale) regardless of the gain or loss recognized in the future. This means you could have a taxable gain due to the California even if the eventual sale of the downstream property results in a loss.

• You must file California Form 3840 every year until the deferred gain or loss is recognized. You sell in 2024, and have zero footprint in California. You feel good. However, you will file FTB 3840 in 2024, 2025, 2026, etc. until some future sale triggers the recognition of a gain or loss for the 2024 transaction. Yay (not)! Also, FTB 3840 is a standalone form; it does not require a complete California tax return (540, 540NR, etc.).

Realized and recognized are terms of art in the accounting profession. In accounting geek-speak, realized gain is defined as the net sale price minus the adjusted tax basis. Recognized gain is the taxable portion of the realized gain. Don’t get too hung up on this.

Again, every state is unique, and every like-kind exchange is equally unique.

Reverse 1031 Exchange

We don’t want to spend too much time on reverse 1031 exchanges. They are an important tool, and there are several qualified intermediaries who can further assist. The generalist gist is this- you purchase the replacement property first. It is amazing. It will add nicely to your real estate investment portfolio. You have a boat anchor to unload first, right? However, you don’t want to let this new property slip away. What do you do? Ergo, the reverse 1031 like-kind exchange.

All the same rules apply to a traditional 1031 like-kind exchange. The high-level process involves the use of an Exchange Accommodator Titleholder. This arrangement basically “parks” the replacement property until the relinquished property is sold, and the exchange loop can be closed.

These are tricky but also very powerful when timing and market conditions don’t exactly align and provide convenience to your real estate investment life.

721 Exchange

Under IRC Section 721, “No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.”

We won’t spend much time on these, but you should know that you generally exchange real estate property for units in a partnership entity. The entity is a real estate investment trust (REIT), which often holds real estate through an operating partnership known as an umbrella partnership real estate investment trust (UPREIT). Are there rules and hiccups? Of course!

Delaware Statutory Trusts (DST)

Like 721 exchanges, we won’t spend too much time on Delaware Statutory Trusts, but you should know they exist. A DST is a separate legal entity created as a trust under Delaware Statutory Law and allows you to co-invest with other investors in one or numerous properties. These are also called a DST 1031 exchange.

They can come to your exchange rescue in a handful of ways. You don’t have to personally qualify for the debt associated with the replacement properties. DSTs can help eliminate boor or other transaction inequalities. They can serve as your backup plan and help meet 1031 like-kind exchange deadlines.

Not all that glitters is gold so careful research and planning is necessary.

Tax Bomb

While it might go without saying, we feel compelled to remind real estate investors that 1031 like-kind exchanges can be a tax bomb down the road. Sure, if you never sell and your kingdom passes to your heirs, they will likely enjoy a step-up in basis which wipes out the deferred gains. However, if you look to sell a rental or two every so often to augment retirement income, the depressed cost basis from a series of daisy-chained 1031s could be a tax surprise.

Cost Segregation Study on Replacement Property

We don’t want to get far into the weeds on this, but there is something you should be aware of when you double stack your cost segregation reports. For example, let’s say you purchase a $200,000 rental property, and with accelerated depreciation your adjusted basis is $100,000. When you perform a cost segregation study on your replacement property, you might be limited. How?

Original Purchase Price of Relinquished Property (a)	200,000
Depreciation Taken (b)	100,000
Adjusted Basis of Relinquished Property (a – b)	100,000
Replacement Property Purchase Price (c)	400,000
Assumed Net Cash Paid in 1031 Exchange (e)	200,000
Adjusted Basis of Replacement Property (a – b + e) (f)	300,000
Adjusted Basis of Replacement Property (f)	300,000
Replacement Property Purchase Price (c)	400,000
Allowable Cost Seg Ratio (f divided by c) (g)	75%

Our apologies if this blows things up a bit. The big takeaway is that your adjusted basis of the replacement property is based in part on the relinquished property. From there, a ratio is derived by comparing the adjusted basis to the overall purchase price of the replacement property. In the example above, a ratio of 75% is indicated.

When you perform a cost segregation study on the replacement property, and nice little buckets of 5-, 7- and 15-year property are detailed, you will apply the cost segregation ratio to determine a limit like so-

	5-Year	7-Year	15-Year
Cost Segregation of Replacement Property	25,000	15,000	30,000
Allowable Cost Seg Ratio (g)	75%	75%	75%
Allowed Property Value per Cost Seg Ratio Limit	18,750	11,250	22,500

Revenue Procedure 2008-16

1031 Like-kind exchanges are lovely tools to kick the tax bill down the road, and whenever there is free money, or at least the perception of free money, the gamers spring into action. What if you could exchange your vacation or second home by calling it an investment property? That would be amazing, right?

In IRS Revenue Procedure 2008-16, coming off the heels of Moore v. Commissioner, T.C. Memo. 2007-134, the IRS stated-

In Moore v. Commissioner, T.C. Memo. 2007-134, the taxpayers exchanged one lakeside vacation home for another. Neither home was ever rented. Both were used by the taxpayers only for personal purposes. The taxpayers claimed that the exchange of the homes was a like-kind exchange under § 1031 because the properties were expected to appreciate in value and thus were held for investment. The Tax Court held, however, that the properties were held for personal use and that the “mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.”

As such, the IRS came up with some rules. Frankly, they are quite easy to comply with and offer some flexibility. To comply with IRS Revenue Procedure 2008-16, the vacation home (relinquished property)-

1. Must have been owned by the taxpayer for at least 24 months prior to the 1031 like-kind exchange (the “qualifying period”).

2. Must have been rented for at least 14 days (at fair market rates) in each of the 12-month periods immediately prior to the exchange.

3. Was not used for personal purposes for more than 14 days or 10% of the number of rented days at fair market rates (whichever is greater) during each of the 12-month periods.

Some notables-

• Must be rented for at least 14 days in each year; not just one of the years.

• The language reads 14 days or 10% of the actual rented days. So, if you rented the property out for 200 days at fair market rates, you could use it personally for 20 days.

• The replacement property (the acquired property) follows similar rules for the next 24 months.

The IRS states in their IRS Revenue Procedure 2008-16 that they will not challenge the validity of the 1031 like-kind exchange if real estate investors follow this mini safe harbor. How nice!

Pulling Money Out Your 1031 Like-Kind Exchange

The problem with selling a real estate investment and performing a 1031 exchange is that your equity is all tied up in the property or series of properties. If you directly take cash out of the deal then this call boot, and is likely taxable income (although there might be some thoughtful tax planning benefits that we discuss in a bit).

What can be done? Once the exchange is completed, you can refinance the debt on the replacement property to pull out cash. You might subscribe to equity stripping to lower your liability exposure or you might want to deploy that cash into other investments. Cash is king, right?

If you are not a big fan of taking on more debt, you can also run a parallel system. This works in either a debt reduction or a cash-out refinance situation. How this works is simple- you keep the cash safely invested at a rate of return that is similar to your cost of debt. At any point where you are not comfortable with the debt or you are not finding better alternative uses for the cash, you can pay down or pay off the loan. We say “similar to your cost of debt” since you don’t have to completely cover the cost of debt; having options is nice and it might be alright to pay a little extra to have those options. Buy comfort.

Keep in mind that you will need enough income to service the debt. Also, WCG CPAs & Advisors recommends not refinancing the relinquished property prior to the 1031 like-kind exchange. This might appear like an end-around to pull cash out of the exchange transaction which is frowned upon by the IRS.

Thoughtful Tax Planning with 1031 Exchanges

There are two scenarios where a 1031 like-kind exchange might not be the ideal tax planning move. First, let’s say you have passive activity losses that are being carried forward from the rental property itself or from other similar passive activities (such as other rentals or rental property investments), or both.

By selling outright, your capital gains might be sheltered with related passive activity losses plus you have direct access to the cash. This can be viewed in a similar vein to cost segregation where the play is to accelerate your access to cash. Time value of money type stuff.

The other scenario is similar and involves long-term capital gain losses either from prior year carryovers or current year transactions. Let’s say you sold some stock a bit ago at a significant loss. This loss carryover gets chipped away at $3,000 per year or when you have other capital gains. For example, you have $250,000 in long-term capital loss carryover. If you did nothing, it would take 84 tax returns to completely absorb these losses. Barf.

Alternatively, you could skip a 1031 exchange altogether or structure it carefully to throw some capital gains against your $250,000 loss carryover. You might still have depreciation recapture, but it might be a small price to pay for tax-free access to the remaining cash.

Deferring capital gains is always an objective, but it must be met with careful tax planning if you have passive activity losses or long-term capital losses, or both. WCG CPAs & Advisors recommends a comprehensive tax plan showing the depreciation recapture and capital gains effects before considering a 1031 like-kind exchange. Gain knowledge. Be informed. Make decisions.

Problems with 1031 Exchanges

There are a bunch of considerations when contemplating a 1031 like-kind exchange-

• If you are selling the property at a loss, you might be better to take the depreciation recapture hit today, regroup and move along.

• Feeling the massive pressure to identify the replacement properties within 45 days and then actually purchase one of them can be a lot. You might make a bad choice by either buying a lousy asset or paying too much, or both, because of the time pressures. The “gotta buy something” is not a good feeling and rarely yields a good result.

• Owning the relinquished property in a business entity and buying the replacement property in your personal name, or vise-versa, can invalidate the exchange. The tax identity must be maintained from the relinquished property ownership to the replacement property ownership. This can be a problem where you own a property in a partnership such as a multi-member LLC and you title the replacement property as tenants in common (TIC) with each named member of the former LLC. The like in like-kind extends a bit to the ownership as well.