Like-Kind 1031 Exchanges

Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.

Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.


Note: The above information references an Internal Revenue Code (IRC) section. A link to the Internal Revenue Code is included for the convenience of those who would like to read the technical reference material.

According to the Section 1031 of the Internal Revenue Code, the properties exchanged must be of "like kind". Like Kind meaning of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties, regardless of whether the properties are improved or unimproved. Personal property used mainly in the United States and personal property used mainly elsewhere would not qualify as like-kind properties. Any property that is classified real estate in any of the 50 U.S. states, and in some cases, the U.S. Virgin Islands would be qualify for a "like kind" exchange.

The proposed "Tax Cut and Jobs Act" of 2017 would restrict 1031 Exchanges to only Real Estate.  What types of "like-kind" exchanges are currently possible? Continue reading below . . .

Quality of properties in a like-kind exchange

Any two assets or properties that are the same type would make an exchange between them tax free. To qualify as like kind, two assets must be of the same, but do not have to be of the same quality. type (e.g. two pieces of residential real estate)

Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties. Personal properties of a like class are also like-kind properties. However, livestock of different sexes are not like-kind properties.

What property is like-kind to my property?

When it comes to real estate, all real property is like kind to all other real property. For example, farm land can be exchanged for an office building, a condominium can be exchanges for a trailer park. The definition of real estate will be defined by the state law of the jurisdiction in which the property is located. Our business focuses on exchanges of real estate. Certain other tangible personal property can be exchanged, like airplanes and equipment. Whether this property is like kind is determined by reference to certain industrial classifications. We can handle exchanges of real estate or personal property.

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What qualifies as a like kind exchange?

To qualify for a like-kind exchange, certain rules must be followed:

  1. The relinquished and replacement property must be held either for investment or for productive use in a trade or business.

  2. A personal residence cannot be exchanged.

  3. The asset must be of like-kind.

Do I qualify for a 1031 like-kind exchange if I flip properties?

“Dealers” in terms of 1031 exchanges are taxpayers who hold real estate as inventory, or who purchase real estate for re-sale. If you flip houses, you would be considered a “Dealer” and therefore not qualify for a 1031 exchange. Resell properties are not eligible for Section 1031 treatment. However, if a taxpayer is a dealer and an investor, he or she can use Section 1031 on qualifying properties. Personal use property would not qualify for Section 1031.

Example of a Like-Kind Exchange

Single Member LLCs as Tenants in Common

Limited Liability Companies are young creatures recently created by State statutes. By contrast the law of tenants in common is centuries old, much of it dating back to English law. In a May/ December romance these are wed into what is often the best structure for holding multiple owner investment real property.

The limited liability company is the usual vehicle for holding real estate. These entities are easy to create and manage. They separate out the risk of owning the property, thereby protecting the other assets of the members (owners). Members can own various percentages of the LLC according to their contribution. For multiple member LLCs the entity obtains a Federal EIN and files a partnership tax return with tax incidents reported to the members on form K-1.

However, the use of this form of ownership can create unforeseen problems when the property is sold at a gain. When real property, owned by an LLC, is sold at a gain, the LLC may perform a 1031x at the partnership level. In that case the LLC sells the relinquished property and the LLC buys the replacement property in accordance with the rules of IRC section 1031. But often the various members of the LLC have different goals when the relinquished property is sold. They want to go their separate ways. When this situation arises, several unsatisfying solutions are tried:

  1. 1. The members that want to stay together buy out the departing members. But this takes new cash, concentrates risk in this asset for those staying in, and prevents the departing members from doing their own 1031x.

  2. 2. The LLC is dissolved, and each member is deeded their fractional interest in the real property prior to sale. Then each owner decides whether to perform their own 1031x. This is known as a “drop and swap.” But whether such 1031x transactions will be honored by the IRS is an open question. These transactions require special reporting to the IRS (lines 13 and 14 of Form 1065) and the State of California is scrutinizing these transactions, questioning whether the “held for investment” requirement of all 1031x transactions is met.

  3. 3. The members that want to stay together do so, maintaining the LLC as an intact entity, but with fewer members. The departing members are deeded their respective fractional interests in the real estate. The property is sold with the LLC performing a 1031x and the new co-owners of the real property cashing out and recognizing (paying) income tax. This solution creates problems if the sale doesn’t go through.

Other problems can arise when a single uncooperative member of an LLC objects to any change in LLC ownership structure. Moreover, none of these suggestions work when a LLC is selling only one of several properties that it owns.

A Solution

Tenants in Common with limited restrictions.

Under IRC section 1031 all real property is like kind to all other real property if the qualified use test is met. Necessarily, a tenant in common interest in one property can be 1031 exchanged into a tenant in common interest in another property. However, the laws governing tenants in common (also called co-tenants or co-ownership) imbues the co-owners with certain rights which are cumbersome, especially when the tenants in common are not related by blood or fealty. Tenants in common have the right to occupy the property, the right to sell or mortgage their share of the property, the right to force the sale of the whole property (partition) and no obligation to share in expenses unless specifically agreed. These rights are inimical to investors combining their funds to buy investment real property. So, while tenant in common interests can be 1031 exchanged their rights must be restricted so that the investment goals of the group can be met.

The IRS published Rev. Proc. 2002-22 to assist with this problem. That ruling sets forth 15 criteria by which a tenant in common agreement, which limits the rights of tenants in common, will be judged. If too many of the criteria are not met then the tenants in common will be treated as having formed a partnership, will be taxed as a partnership, and will be restricted to doing 1031 exchanges at the partnership level. The most important of these 15 criteria are:

  1. 1. Each tenant in common must hold record title ownership.

  2. 2. No more than 35 tenants in common.

  3. 3. No filing of any partnership tax return.

  4. 4. Tenants in common can be forced to offer their interest to the other tenants in

  5. 5. Management agreements cannot be for more than one year.

  6. 6. Any sale, leasing or mortgaging of the whole property must be by unanimous

  7. 7. Profits and losses must be shared according to fractional ownership.

  8. 8. Tenants in common limited to investment activity not engaged in business.

Limiting Liability and the Single Member LLC

But what about the limited liability afforded by LLCs? Tenant in common ownership, by itself, does NOT separate the risk of property ownership and does NOT protect the other assets of the tenants in common. Again, the IRS has rescued the situation by declaring that single member LLCs are “disregarded entities” for capital gains tax purposes. By disregarded they mean that a single member LLC need not have an EIN nor does it need to file a separate tax return!! Instead the tax incidents of any real property owner by a single member LLC are reported directly on the individual tax return of the member! By combining ownership of property as a single member LLC with a tenant in common agreement you achieve maximum 1031 exchangeability with limited liability.

Conclusion

When multiple owners join forces to buy real estate they often overlook their 1031 exit strategy. To achieve limited liability with 1031 exchangeability, real property investments can be structured with several single member LLCs as tenants in common operating under a tenant in common agreement which complies with Rev, Proc. 2002-22. And everyone enjoys a good romance.

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