The concept of like-kind exchanges originated almost a century ago, but the tax-deferred structure we know today was created in 1954. Section 1031 of the U.S. Tax Code allows taxpayers to exchange property for similar property without incurring a tax bill. Until recently, Section 1031 allowed for both real and personal property like-kind exchanges, but when Congress passed the Tax Cuts and Jobs Act (TCJA) in December 2017, they removed the personal property allowance making only real property eligible for tax-deferred treatment.
Like-Kind Exchanges: The Basics
Like-kind exchanges are strategies taxpayers use to defer capital gains tax on sales of investment property. In this strategy, taxpayers can defer paying tax* on capital gains recognized from the sale of investment property if they purchase replacement property that is of “like-kind.” In real estate, the definition of “like-kind” is broad; the property must be of “the same nature or character” but can be of different grades or qualities. This means real estate investors can exchange an apartment building for two single-family rental homes, a duplex for a restaurant space, or a piece of farmland for a land slated for development. Only when the replacement property is sold will the original gain be taxable.
*A portion of the gain may be taxable initially if the new property exceeds the value of old property, or if non-like-kind property (called “boot”) is exchanged.
What This Change Means
Two years ago, the TCJA restricted like-kind exchanges to real property, and taxpayers selling both real and personal property in one transaction were at a loss. When taxpayers sell real estate and personal property – like selling an office building outfitted with cubicles and desks – they can only defer capital gains attributed to the sale of real property. The capital gain attributed to personal property is currently taxable.
Cost Segregation Almost a Necessity
To receive the benefits under Section 1031 when selling real and personal property in one transaction, taxpayers must allocate sales proceeds between the different property categories: land, building, and personal property. One way to do this is to commission a cost segregation study.
Cost segregation studies can be performed by tax professionals, attorneys, and qualified appraisers. The professionals will look at the property deed, blueprints, construction history, and asset listings, and will inspect the physical property. They will base their allocations on comparable sales, book value, governmental surveys, estimates, or using some combination of these factors. This allocation will be subjective, and that’s ok. In fact, the real/personal property split may be different for the buyer than the seller. Many sellers allocate little money to personal property when their land and buildings are the true drivers of their sales. Taxpayers will simply need to be prepared to corroborate their conclusions. If audited, the IRS will want to know their methodology.
Allocating sales prices to different types of property can be costly and time consuming, so many taxpayers remove personal property from the equation altogether.
Selling Personal Property
Taxpayers always have the option to sell their personal property separately from their real property. Doing so may be time consuming, but there will be no question how to allocate the sales price to each asset, and the investor can save money on an appraisal.
Abandoning Personal Property
Before taxpayers sell their property, they can mark the personal property within it as “abandoned” and record an ordinary loss for the assets’ remaining book value. Voluntarily abandoning property will be a simple accounting entry. If assets have associated debt, the entry and tax recognition will be a bit more difficult and investors should discuss their plans with a tax professional.
Contributing Personal Property to Charity
Taxpayers can donate their unwanted property to charity. Noncash charitable contributions are deductible, but assets valued above $5,000 and vehicles will need to be appraised.
Real estate professionals have been using 1031 exchanges for decades. They are reliable methods of deferring capital gains tax and can increase investors’ purchasing power for their next investments. If you have any questions about like-kind exchanges or are considering a cost segregation study, please reach out.
Information in this article is based off content from Jonathan Ciccotelli' s article in Crain's Cleveland Business.