By Joseph E. Tierney IV & Michael Van Someren
In today’s high-tax environment, many individuals and business owners are seeking renewed tax strategies when expanding their businesses and investments. Hence the recent uptick in the number of tax-deferred exchanges under Section 1031 of the Internal Revenue Code (“IRC”) being completed. The increased volume of § 1031 exchanges is attributable to a number of factors including: 1) the need for businesses to expand as the economy continues to improve; 2) the increase in property values since the Great Recession; 3) an increase in financing availability; and most significantly, 4) the increase in the capital gains tax rate as well as the Medicare surtax on net investment income instituted by the Affordable Care Act (the “ACA”). By using § 1031 (or like-kind) exchanges, individuals and businesses have the ability to sell their investment or commercial property, defer their tax liability on the sale of that property, and increase the amount of money they have available to replace the property sold.
Just as the like-kind exchange has started to regain its popularity, there have been proposals by both the Republicans and the Democrats in Congress to abolish or limit the amount of gain that can be deferred under a like-kind exchange. While the likelihood that any of these proposals will successfully get through Congress may be small, those individuals and businesses that are concerned about such changes and have plans to expand their businesses or investments should consider undertaking a like-kind exchange sooner rather than later.
What Is a Like-Kind Exchange? Office Building = Pasture.
A like-kind exchange is a generic term for a purchase and sale transaction in which property that is the same or similar in nature or character is essentially swapped by the parties involved. When done correctly, the gain realized by the seller in such a transaction qualifies for income tax-deferral under IRC § 1031. When property is sold (the “relinquished property”), and the proceeds from the sale of the relinquished property are used within a designated period of time to purchase new property that is “like-kind” with the relinquished property (the “replacement property”), the seller can defer the income tax owed on that portion of gain from the sale of the relinquished property that is used to purchase the replacement property. Whether the replacement property is like-kind with the relinquished property typically is determined by state law. There is no limit to the number of times a seller may defer gain under § 1031, and sellers only recognize the gain on the sale of relinquished property once they take cash out of the transaction.
For a transaction to qualify as a like-kind transaction under § 1031, three primary requirements must be satisfied. First, the relinquished property and the replacement property must be like-kind. For relinquished property that is not real estate, the characteristics of replacement property that qualifies as like-kind can be very restrictive (e.g., a rooster is not like-kind with a hen). Conversely, for relinquished property that is real estate, the replacement property can be any type of real estate. In the eyes of the IRS under § 1031, there is no difference between an office building and a pasture. Further, fee interests in real estate may potentially be exchanged for interests in easements, long-term leases, and water rights.
Second, the seller may not take possession of the proceeds from the sale of the relinquished property. To accomplish this, a qualified intermediary, often an affiliate of a title insurance company, is utilized to hold the proceeds from the sale of the relinquished property until the closing on the replacement property.
Finally, the sale of the relinquished property and the purchase of the replacement property must be completed within 180 days. This restriction may be difficult to meet unless the seller has planned out the purchase process before entering into a contract for the sale or purchase of the relinquished or replacement properties.
What Are the Benefits Of a Like-Kind Exchange? Tax Deferral.
No surprise, the primary benefit of like-kind exchanges is the tax savings. On a hypothetical traditional sale of real estate in which the seller has a gain of $1,000,000.00, the seller will likely have a tax liability of at least $238,000.00. This tax liability is the sum of 1) 20% capital gains tax, and 2) 3.8% Medicare surtax. The seller may also have an additional tax liability equal to 25% of the value of any depreciation the seller wrote off in previous years. In that same hypothetical sale, if the seller were to structure the sale as a like-kind exchange, the seller could use the entire $1,000,000.00 gain to purchase a replacement property or properties instead of $762,000.00 which would be available after a traditional real estate sale.
In addition to the tax benefits, like-kind exchanges can be flexible to meet a variety of needs. For example, in Milwaukee, where manufacturing is a major industry and industrial building vacancy rates as of December 2014 were at 5.1%, a manufacturer that needs to expand may find it difficult to find property that meets its expansion needs. Further, it may find that those properties that are available are being sold at a premium. Some manufacturers may stumble upon a perfect location before selling their current location. Others may decide that it is most economical to build a new facility to their specifications. Both situations may be facilitated under § 1031 by structuring the exchange as either a “reverse exchange” or a “build-to-suit exchange.” In either situation, utilizing like-kind exchange is likely to free up additional capital.
Issues Arising During Like-Kind Exchanges: Complex Requirements Hamper Qualifications
Like-kind exchanges can range in complexity from the straightforward exchange of fee simple ownership interests in real estate to the more complex exchange of tenancy-in-common interests, syndication of tenancy-in-common interests, or the exchange of a combination of ownership interests. No matter the property being exchanged, like-kind exchanges offer a somewhat flexible option to defer income tax liability, expand purchasing power, and increase business investment. However, even with the most straightforward exchange there are many detailed requirements that must be satisfied before the transaction will qualify for tax deferral. As one would expect, as the complexity of the exchange increases, so too do the requirements that must be satisfied to qualify for income tax deferral. Failure to satisfy even one of the requirements will result in a large, unanticipated tax bill at the end of the year. Therefore, it is important that property owners who wish to carry out a like-kind exchange consult with a qualified professional who understands how to meet all of the IRS’s requirements for carrying out a like-kind exchange.
If you have any questions about the pros and cons of like-kind exchanges or are interested in undertaking an exchange with respect to real estate or personal property, please contact your Davis & Kuelthau attorney for assistance or the authors, Joseph E. Tierney, IV, at 414.225.1471 / email@example.com, or Michael Van Someren, at 414.22531433 / firstname.lastname@example.org.