Like-Kind Real Estate Exchanges in Illinois: Overview of Section 1031

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August 13, 2018
Author: Michael M. Caron
Organization: Lyon & Caron LLP


A. Code Section 1031. Code Section 1031 provides an exception to the general rule requiring current recognition of gain or loss realized upon the sale or exchange of property.

1. Under Code Section 1031(a)(1), no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a “like-kind” which is to be held either for productive use in a trade or business or for investment.

2. Code Section 1031 provides a list of exceptions to which the general rule of Code Section 1031 does not apply. See II.D. below

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3. Code Section 1031(a)(3) provides for non-simultaneous exchanges carried out within a strict time frame. These provisions were enacted in 1984, in response to the decision in Starker v. U.S., 602 F.2d 1341 (9th Cir. 1979). See Part IV below.
a. Replacement property must be identified within 45 days after the taxpayer transfers the relinquished property; and
b. The replacement property must be acquired within the earlier of 180 days after the transfer by the taxpayer of the relinquished property or the due date (determined with regard to extension) of the taxpayer’s tax return for the year in which the taxpayer transferred the relinquished property.

4. A transfer may involve both a like-kind and non-like kind property. Non-recognition treatment does not apply to the nonlike- kind property.

5. The regulations define like-kind at Treas. Reg. §1.1031(a)-1(b). The words “like-kind” refer to the nature and character of the property, and not to its grade or quality. Real estate is treated very liberally, and the regulations provide that whether the real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality, and not to its kind or class. On the other hand, what constitutes like-kind personal property is treated very narrowly.

6. Code Section 1031 is not subject to election or waiver. However, non-recognition can be avoided, by intentionally falling outside Code Section 1031.

7. Gain realized on Code Section 1031 exchange must be recognized to the extent that the gain would be taxable as ordinary income under the recapture provisions of Code Section 1245 and 1250 (to be distinguished from the long term capital gains rate applicable to straight line depreciation of 25%). Any realized gain will also be recognized to the extent of the sum of the money (including liabilities relieved of on the relinquished property) received and the fair market value of non-qualifying property received. No loss realized on a Code Section 1031 exchange is recognized even if money or non-qualifying property is received

B. Why Exchange under Code Section 1031?

1. Some of the reasons are listed below:
a. Preservation of equity by not paying tax on realized gain.
b. Generation of cash flow by exchanging unimproved land for income producing property.
c. Receipt of nontaxable cash by exchanging for mortgageable property, which is then refinanced after, and independently of, the exchange.
d. Acquisition of property that is appreciating faster than the property transferred.
e. Consolidation of assets by exchanging many properties for one equal to or greater than their combined values.
f. Increase asset size by exchanging up and acquiring properties with larger total value by using the profit realized through appreciation and loan amortization.
g. Relocation of business facilities without depleting equity by paying tax.
h. Conservation of an individual’s estate by exchanging throughout life without loss of appreciated value to tax.
i. Completion of a transaction not otherwise feasible due to the tax consequences.
j. Diversification of holdings and spread of investment risk among several smaller properties.
k. Reduction of property management problems by exchanging for property that is management-free or capable of supporting professional management.

2. Tax law changes since 1984 have created a greater incentive to utilize like-kind exchanges.
a. The 1984 amendments to Code Section 1031 gave approval to certain qualifying non-simultaneous exchanges.
b. The Tax Reform Act of 1986 (and certain other legislation) eliminated many of the tax benefits previously enjoyed by owners of real estate.

(1) Under current law, the maximum federal tax rate on long term capital gains (assets held more than one year) is as follows: straight line real estate depreciation is taxed at 25%; the balance of the taxable gain would be taxed at the long term capital gains rates (these have been changed from 15% effective for 2013 and later years, to 20% for persons with taxable incomes in excess of $400,000 (single) or $450,000 (married filing jointly). In addition, starting in 2013, the new 3.8% Medicare Surtax from the Affordable Care Act applies to the lesser of net investment income or the excess of “modified adjusted gross income” over $200,000 (filing single) or $250,000 (married filing jointly). These are even more reasons to consider a 1031 to defer income taxes.

(2) Depreciation periods were lengthened for real estate (27.5 years for residential and 39 years for commercial), and the cost of real estate must be recovered on a straight-line basis.

(3) For individual investors, losses generated by rental real estate are subject to Code Section 469 limitations on losses and credits from passive activities.

(4) Reduction of the tax benefits of installment sales as depreciation in excess of straight line would be taxed as ordinary income in the year of sale. Code Section 453(i). (1984 amendments to Code Section 453; however, unlikely to apply to any transactions in 2014 or later years as this “excess depreciation” has most likely been burned off). Also note that under Code Section 453, liabilities in excess of basis are taxable in the year of sale.

(5) Application of Alternative Minimum Tax (“AMT”) rules. Real estate or other capital gains may push someone into AMT, as a result of the phase out of exemption amounts.

a. Incentive to defer taxes great where substantial appreciation has occurred or simply where significant tax depreciation has been claimed.
b. A taxpayer who desires to sell real estate but who plans to reinvest the proceeds of sale into a new real estate investment will have to carefully compare the tax results of a sale and purchase of new property with a like kind exchange.
c. In an economic analysis of a Section 1031 exchange versus sale and repurchase, consider the tax paid on the sale versus that deferred on exchange. Also to be considered are the following items:

(1) The depreciation deductions on purchased property versus the depreciation deductions on exchanged property, taking into account the taxpayer’s ability to use the deductions (an owner may consider a cost segregation study, to maximize allocations to personal property and any available bonus depreciation on personal property);

(2) Whether the taxpayer has other losses or credits that can shelter the gain; and

(3) The character of the gain recognized on the sale: capital or ordinary?

f. Code Section 1031 may be a target of future revenue raising efforts. Please refer to the discussion in the industry updates at the start of this program. Under a tax reform proposal issued by David Camp, Chairman of the House Ways and Means Committee, titled the Tax Reform Act of 2014, the draft bill proposes to repeal Section 1031, effective for transfers after 2014, subject to an exception for transfers made pursuant to a binding contract entered into prior to January 1, 2015, and consummated before January 1, 2017. The administration’s fiscal 2015 budget plan also proposes to curtail like-kind exchanges by limiting the amount of gain deferred to $1 million per taxpayer per taxable year.

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