Tax Planning for Business: 10 Section 1031 Exchange Facts You Need to Know

Diane Gilabert writes: Section 1031 exchanges are a powerful tax planning tool. But watch out: they are full of tricks and traps. The basics of a like-kind exchange are straightforward, but very few are structured as simultaneous swaps of one property for another.   Here are 10 facts about section 1031 exchanges that you need to know.

1. Section 1031 doesn’t only apply to real estate.

Example: Larry exchanges a truck used in his delivery business for a new truck. The dealer gives Larry a $2,000 trade-in allowance for the old truck. The old truck is fully depreciated. The transaction qualifies as a like-kind exchange and no gain is recognized. The tax basis of the new truck is reduced by the $2,000 trade-in allowance applied.

2. Section 1031 is not elective

It is difficult to structure a transaction so that it avoids section 1031. Check out Revenue Ruling 61-119. The taxpayer entered into separate contracts for the sale of used business equipment and the purchase of new equipment, but the IRS ruled the transactions were related and treated them as one.

Unlike the installment sale rules, there is no election out of section 1031.

3. Section 1031 applies to gain or loss

Example: Bernie exchanges a truck used in his delivery business for a new truck. The dealer gives Bernie $2,000 trade-in allowance for the old truck. The old truck has an adjusted tax basis of $3,000. The transaction qualifies as a like-kind exchange, and no loss is recognized. The tax basis of the new truck is increased by the $1,000 loss that was not recognized on the trade in.

4. Section 1031 need not apply to both parties

Example: Jack owns a residential rental property that he wants to exchange for one with better cash flow. Jill owns a personal residence that she wants to sell in order to downsize to a condo. Jack finds a buyer for his rental and uses a qualified intermediary. He identifies Jill’s home as his replacement property within the required 45 day period, and the transaction closes within the required 180 days. The transaction qualifies as a section 1031 exchange with respect to Jack: any gain or loss is deferred. For Jill, the transaction is the sale of a personal residence, so section 1031 will not apply.

5. The 2 year holding period applies to both parties in a related party exchange

Section 1031(f) requires that if an exchange occurs with related parties, the property must be retained for at least 2 years from the date of the exchange. Otherwise any gain or loss on the original exchange is recognized. The requirement to hold property for 2 years applies to both parties involved with the exchange.

6. Section 1031 can apply even if the replacement property is acquired before disposition of the property being relinquished

The concept of a reverse exchange was controversial for many years, but the IRS finally acquiesced to it and issued Rev. Proc. 2000-37 with safe harbor requirements.

7. The basis rules of section 1031 can produce unexpected results

Example: Dan exchanges unimproved real estate (basis of $15,000 and a fair market value of $30,000) for an apartment building owned by George (land with a fair market value of $10,000 and building of $20,000). The property acquired takes the $15,000 basis of the property transferred, allocated on the basis of their relative fair market values on the date of the exchange. Therefore, the basis allocated to the land is $5,000 ($10,000/$30,000 x $15,000) and the basis allocated to the building is $10,000 ($20,000/$30,000 x $15,000). In this case, Dan converted nondepreciable basis to largely depreciable basis. George lost all of his depreciable basis and no longer has depreciation deductions.

8. Exchanging property with potential section 1245 recapture does not automatically result in recognized gain (unlike an installment sale).

Example: Mindy exchanges a copier for another copier in a transaction that qualifies under section 1031(a).  Both copiers are 1245 property. No section 1245 recapture is triggered because Mindy did not receive any non-1245 property.

If non section 1245 property is received in a transaction with section 1245 recapture property, some gain due to recapture may apply. Refer to rules described in Reg. 1.1245-4(d)(4).

9. Section 1031 exchanges must be reported even if no gain or loss is recognized.

An exchange is reported as a disposition on either Form 4797 or Schedule D,  whichever applies, and also onForm 8824. Form 8824 requires descriptions of the property relinquished and received, identification of any related person who is a party to the exchange, and calculations of realized gain, recognized gain, and the basis of like-kind property received.

10. Electing out of partnership treatment under section 761(a) does not necessarily mean an exchange involving property owned by the partnership will otherwise qualify under section 1031(a).

Section 1031(a)(2)(D) contains an exception that an exchange of  partnership interests cannot qualify as a like kind exchange under section 1031(a). However, an amendment was added in 1990 to recognize partnerships with a valid election under section 761(a) as treating the partners as separately owning an interest in each asset for purposes of section 1031.

However, the IRS has been strict in applying this exception and has challenged the validity of section 761 elections in certain situations.