The Internal Revenue Code (IRC) requires sellers of investment or business property to pay taxes on any gains realized from sales of such property. However, Section 1031 of the IRC (§1031) has provided an exception to the general rule by enabling what has become known as the "§1031 exchange." The §1031 exception involves the deferment of recognition of gains, and thus, the obligation to pay income or capital gains taxes on them if a seller reinvests proceeds in a similar property in a coinciding (within specific time limits), integrated transaction. But which similar properties qualify are limited to those that are deemed "like-kind" under §1031 and the relevant Treasury Regulations (See Treas. Reg. 1.1031 and its various subsections).
§1031 provides that to qualify as a "like-kind" property, both the property being sold and the property being purchased must be held for use in a trade or business or for investment and must not be: (i) inventory or stock in trade; (ii), stocks, bonds or notes; (iii) other securities or debt; (iv) partnership interests; or (v) certificates of trust. "Like-kind" refers to the nature or character of the property and not its grade or quality. All real estate will be like-kind to any other real estate. Thus, a parcel of vacant land can be like-kind to a commercial building. On the other hand, real estate will not be like-kind to personal property.
Most §1031 exchanges are done through a qualified intermediary, who is charged with holding the proceeds from the sale of the property being relinquished. The seller has no more than 45 days from the date of closing of the sale to identify a replacement, like-kind property for the exchange and has 180 days from the date of closing of the sale to close on the purchase the replacement to complete the exchange. These time limits are absolute and are not extended for holidays, weekends or anything short of a major disaster that prompts the government to grant special relief (such as after September 11, 2001).
Interestingly, personal property is also eligible for §1031 exchanges. However, the rules are much stricter as to what personal property is like-kind to other personal property, and such personal property must be in either the same general asset class or product class, according to the North American Industry Classification System (NAICS), developed by the Office of Management and Budget (OMB). For example, motorcycles and ATVs would not be like-kind property, and cars and trucks would not be like-kind property despite the fact that all four of them are motor vehicles. Further, wrist watches and wall clocks would not be like-kind property, although they are both time-keeping devices, and cows and bulls are not like-kind property although they are both cattle. On the other hand, artwork of the same type can be exchanged for other artwork of the same type, but while a copyright of a novel may be exchanged for a copyright of another novel, it cannot be exchanged for a copyright of a song.
In his FY 2017 budget, President Obama has proposed to modify the like-kind exchange rules for all real and personal property and to exclude certain personal property from eligibility for §1031 exchanges. The proposal seeks to limit gains eligible for §1031 exchanges to $1,000,000 per taxpayer per year, which would limit the effects of the proposal on small businesses. Further, art and other collectibles would no longer be eligible for §1031 exchanges at all. The proposal grants the IRS rule-making authority to implement the proposals, including aggregating multiple properties exchanged by related parties, so that a series of under $1,000,000 gain exchanges by related parties would be disallowed under §1031 if they exceeded $1,000,000 of gain in the aggregate. The proposal would be effective for all §1031 exchanges completed after December 31, 2016.
These proposals may be prompted by a desire to increase tax revenue. It has been suggested that there is little justification for allowing the deferral of capital gains on the exchange of art or other collectibles, which do not significantly promote economic development. Also, when §1031 was enacted, valuing exchanged property was difficult, but now, with a large industry of qualified intermediaries handling the exchanges, most exchanges are handled on a deferred (within the 180-day requirement) basis, resulting in more exchanges than might have been originally contemplated. Moreover, §1031 can also be conducted in reverse, where the taxpayer purchases a replacement property first, and then has 180 days to sell its property to be relinquished. However, reverse §1031 exchanges are considerably more complex and expensive and require careful planning. Furthermore, a taxpayer may engage in repeated exchanges, indefinitely postponing recognition of the gain. If the taxpayer is an individual, the taxpayer’s estate is given a stepped up basis for appreciated property upon the taxpayer’s death, effectively forgiving all tax on the gain.
President Obama’s proposal, if approved, could severely dampen the pervasiveness of §1031 exchanges. It is unclear whether the government’s concerns are well-founded or whether §1031 exchanges have fueled investment, and thus, benefited the economy. In any event, if the reforms are passed, the widespread §1031 exchange market might change dramatically. If a taxpayer has initiated or contemplates a §1031 exchange, it may be advisable to conclude it before January 1, 2017, when these proposals, if enacted, would take effect. Investors contemplating a §1031 exchange or a significant investment real estate transaction should seek counsel experienced with tax deferred exchanges before entering into these transactions.