Business & Investment

What is a “like-kind” exchange? And how do they affect capital gains taxes?

As a real estate investor, you may want to take down one real estate and exchange it for another. Real estate prices are skyrocketing in many regions. You may have property that you think is full and want to move on to what you think is a greener meadow. fair enough. However, selling a highly valued property will have a current tax impact. Probably a big blow. If you’re going to use your sales to buy an alternative property, that’s the next best result.

what to do? Section 1031 exchanges for rescue. Here’s what you need to know:

what is it Section 1031 exchange, Also known as “like-kind” exchange?

For now, in section 1031 of our beloved Internal Revenue Service, you can postpone the unloading of real estate for which the Federal Income Tax Bill has been evaluated by arranging a section exchange (also known as a like-kind exchange). This old-fashioned operation is one of the major reasons some real estate investors have struck it abundantly over the years.

Earlier versions of the Biden tax system severely limited the ability to postpone taxes on the exchange of Section 1031. The tax increase proposal is now clearly off the table, but it could come back sooner or later if lawmakers take seriously to curb the federal budget deficit. Therefore, it may be a really good idea to exchange Section 1031 early rather than later, while the current taxpayer-friendly rules are still in place.

Section 1031 Exchange Tax Basics

As long as the abandoned property (the property that is unloaded by swap) and the exchanged property (the property that is received by swap) are of the same type, we can arrange the exchange of real estate. It sounds like a potential problem, but it’s not. Anything defined as real estate can be exchanged for anything else defined as real estate.

What is real estate?

Good question. Thankfully, the IRS regulation uses a very wide range of brushes to define real estate for the purpose of Section 1031 exchange. The starting point is that real estate includes land, land improvements, natural products of uncut land, and water and airspace adjacent to the land.

If an interconnected asset works together to provide a permanent structure (for example, a system that provides electricity, heat, or water to a building), the asset may qualify as a structural component of real estate. For example, a gas pipe that fuels a building’s heating system counts as real estate.

The rules also include examples of intangible assets that can be counted as real estate, such as options, leasements, easements, and land development rights.

The rules also provide that real estate that is considered real estate under applicable state or local law is counted as real estate for the purpose of Section 1031 exchange.

Finally, the rules allow the exchange of Section 1031 to receive an “accidental” amount of movables. Accidental movables can account for up to 15% of the total fair market value of real estate. For example, suppose you buy a small hotel worth $ 30 million with a swap in section 1031. Swaps can include up to $ 4.5 million worth of movables (15% of $ 30 million) and the entire package is eligible for Section 1031 incentives.

Key Point: Please contact your tax accountant for more information on what constitutes a property before you get the chance to expect a 100% tax deferred section 1031 exchange.

Impact of “boot”

To avoid the current taxable profits of real estate swaps, you should avoid receiving “boots”. Boot means cash and assets that are not defined as real estate. If mortgage real estate is involved, the boot also includes that the abandoned real estate mortgage (the debt you remove) exceeds the alternative real estate mortgage (the debt you assume).

If you receive boots, you are currently taxed on profits equal to (1) the value of the boots or (2) the overall profit of the transaction based on fair market value, whichever is less. Therefore, even if the amount of boots is small, swaps are mostly tax deferred (rather than completely deferred). On the other hand, if you receive a lot of boots, you can get big tax profit.

The easiest way to avoid receiving a boot is to replace a low value property with a high value property. That way, you pay for the boot instead of receiving it. Paying the trunk does not cause taxable profits on your side of the transaction.

In either case, the tax-exempt profit of Section 1031 swap is carried over to the alternative property and remains tax-exempt until the alternative property is sold in the taxable transaction.

Postponed section 1031 replacement

As you can imagine, it’s usually not impossible for someone who wants to swap Section 1031 to own a suitable alternative property and find another party who wants to swap Section 1031 instead of selling cash. Is also difficult. The benefit of savings is that deferred exchanges can also be subject to tax deferral section 1031 exchange processing.

Deferred exchange rules do not require you to exchange one property directly and immediately with another. Instead, sell the real estate that was actually abandoned in cash, deposit the proceeds from the sale to a qualified broker who can act effectively as an agent, and later find a suitable alternative property, and then the broker will give you Buy the property on your behalf. The general deferred swap mechanism is as follows:

* Transfer abandoned property (property you want to exchange) to Qualified exchange intermediary.. The role of the intermediary is usually to facilitate the exchange of Section 1031 for fees based on the sliding scale according to the value of the transaction. In terms of percentage, brokerage fees are generally very reasonable.

* Next, the intermediary arranges a cash sale of the abandoned asset. The intermediary will hold the resulting cash sales revenue on your behalf.

* The intermediary will use cash to purchase the appropriate pre-specified and approved alternatives.

* Finally, the intermediary will transfer the replacement property to you to complete the exchange in Section 1031.

It’s done! From your point of view, this series of transactions counts as a tax deferred section 1031 swap. Why? That’s because you’ll arrive at a replacement property even if you haven’t actually seen the skid-greased cash for the underlying transaction.

Key Point: See the sidebar for the basic requirements for a deferred section 1031 replacement.

Tax saving bonus

What if you still own a replacement property when you die? Current federal income tax rules completely wash away taxable profits, thanks to another favorable provision that raises the tax base for deceased assets to fair market prices on the day of death. Therefore, under current rules, taxable profits may be postponed indefinitely in a like-kind exchange and may be eliminated if you die while in possession of the property. Wow.

The heir will then have to sell the property and either eliminate the federal income tax or pay a small tax based on post-mortem gratitude. What a hell. Real estate property was created this way without sharing with Uncle Sam.

warning: Earlier versions of the Biden tax system had significantly reduced mortality-based step-up breaks. The tax increase proposal is now clearly off the table, but it could come back sooner rather than later. If it comes back, you can expect it to affect only those who are really rich. I wish you success.


The exchange of Section 1031 can be quite complex, but the tax benefits can be enormous and all the complexity is worth the problem. As mentioned earlier, it is highly recommended that the replacement of section 1031 be done early rather than later. Finally, involve your tax accountant to avoid failure. Arranging a replacement for Section 1031 is not a good DIY project.

Sidebar: Section 1031 Swap Postponement Requirements

Two key requirements must be met for a deferred real estate exchange to be eligible for tax-exempt Section 1031 swap processing.

1. Before the end of 45 days, the replacement property must be clearly identified Identification period.. The period begins when you transfer the abandoned asset. Identification requirements can be met by specifying alternative properties in the written and signed documents passed to the intermediary. In fact, the document can list up to three different properties to accept as appropriate replacement properties.

2. The exchanged property must be received before the end. Exchange period, Can be within 180 days. Like the identification period, the exchange period begins when you transfer the abandoned asset.The exchange period is Just a while ago (1) 180 days after the transfer, or (2) the due date (including extension) of the federal income tax return for the year including the transfer date. If your tax return deadline reduces the exchange period to less than 180 days, you can easily extend your tax return. This will restore the entire 180 days.

What is a “like-kind” exchange? And how do they affect capital gains taxes? What is a “like-kind” exchange? And how do they affect capital gains taxes?

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