CASWELL BELL & HILLISON LLP
FRESNO, CALIFORNIA

SECTION 1031 LIKE-KIND EXCHANGES

Normally, capital gains are recognized and taxable upon the sale of property.  Section 1031 of the Internal Revenue Code provides an exception to this rule for certain exchanges of property. 

If all requirements are met, the tax on gain from the exchange is deferred.  Gains will not be recognized until the person who received property in the exchange sells or otherwise disposes of it.  The most common type of nontaxable exchange is the exchange of property for the same kind of property, or like-kind exchanges.

Requirements
To qualify as a like-kind exchange, the property traded and the property received must be both (1) qualifying property and (2) like property.  Qualifying property must be held either for investment or for productive use in a trade or business.  Typical examples include machinery, buildings, land, trucks, and rental houses.  Like property refers to the nature or character of the property.

All real estate is like-kind to all other real estate, whether or not one or both of the properties are improved.  Similarly, an exchange of personal property for similar personal property is an exchange of like property.

Factors to Consider
In general, three basic factors may be considered in deciding whether a like-kind exchange will make sense.  The exchanger should (1) receive property with a price equal to or greater than that of the relinquished property; (2) have as much, or more, debt in the acquired property as in the property given up; and (3) take no cash out of the transaction.

Partial Exchange is Permitted
An exchange of like-kind property is only partially nontaxable if the taxpayer also receives money or unlike property in an exchange that produces a capital gain.  In that case, the gain is taxable, but only to the extent of the money received and the fair market value of the unlike property.

Deferred Exchange
Because a straight swap of property is often impractical, the Tax Code allows deferred like-kind exchanges.  If the transaction is structured properly, a person can sell one property, have the proceeds held for a period of time, and then use the proceeds to buy new property. 

A deferred exchange will never satisfy the tax requirements if the seller has custody or control of the sales proceeds.

The seller must identify the replacement property within 45 days of selling the relinquished property.  Also, acquisition of the replacement property must take place within 180 days of the sale of the relinquished property, or the due date of the taxpayer’s return for that year, whichever is earlier.

Qualified Intermediary
It is common to use a qualified intermediary in making a deferred exchange of like property.  Be very careful when selecting an intermediary.  This is a murky, unregulated industry, and a number of high-profile cases have arisen in which the intermediary absconded with the funds.

A qualified intermediary is a person who enters into a written exchange agreement to acquire one party’s property and transfer it to a second party, and also to acquire replacement property from the second party and transfer it to the first party.  The agreement must explicitly limit the first party’s rights to obtain in any way the benefits of money or other property held by the intermediary.  A qualified intermediary cannot be either an agent or a relative of the “exchanger.”

Time to Change the Tax Laws
The use of an intermediary is an anachronism of the tax code.  No similar requirement is imposed under Internal Revenue Code section 1033.  Write your congressman and ask to have this provision of section 1031 amended.  The requirement to have an intermediary hold the sales proceeds serves no benefit to the administration of the tax laws, and has caused millions of dollars in losses.

Related Person Exchanges
There are special rules for like-kind exchanges between related persons.  In this context, “related persons” include not only spouses, siblings, parents, and children, but also a corporation in which an individual has more than 50% ownership, and a partnership in which an individual owns over 50% of the capital or profits.  For a like-kind exchange between related persons, the ability to postpone tax liability for the gain from the exchange is lost if either person disposes of the property within two years after the exchange.

© Caswell Bell & Hillison LLP          Attorneys and Lawyers, Fresno, California