As many property owners are aware, while the Federal Government has acknowledged tax deferred exchanges for quite some time, as of the 2023 tax year Pennsylvania became the last state in the United States to acknowledge tax deferred exchanges for state income tax purposes. This has led to several questions about 1031 exchanges. What and who is involved? What are the potential benefits and setbacks for a taxpayer considering such an exchange?
Generally, when a taxpayer sells real or personal property and realizes a gain on the sale, the taxpayer will be required to pay tax on that gain. A like-kind exchange under Section 1031 of the Internal Revenue Code (the “IRC”) is an exception to this general rule. In a like-kind exchange, the IRS allows a taxpayer to sell investment property (the “Relinquished Property”), which can be either real or personal property, and re-invest the proceeds in similar investment property (the “Replacement Property”) without having to pay taxes on the gain associated with the sale of the Relinquished Property.
Importantly, the un-recognized tax on the gain is not forgiven by the IRS, but rather is deferred until a later taxable transaction. To defer the tax on all of the gain from the sale of the Relinquished Property, the Replacement Property (or properties) must be of at least equal value to the Relinquished Property. Additional cash that remains after the acquisition of the Replacement Property may still be taxed.
Tax-deferred treatment is only available for the exchange of investment property. A taxpayer’s personal residence or property maintained for personal use is not eligible. Additionally, property held for the purpose of resale will be considered inventory and will not qualify for a like-kind exchange. Developers that flip real-estate will not meet the requirements for a like-kind exchange because the intent is to re-sell the property as inventory rather than hold it for investment purposes.
A basic like-kind exchange (also known as a forward exchange) transaction must meet several requirements in order to qualify for tax-deferred treatment under Section 1031 of the IRC:
Like-Kind Requirement The properties to be exchanged must be of a like-kind. This like-kind requirement is based on the nature and character of the property. A taxpayer will not, for example, be permitted to exchange equipment for an undeveloped parcel of land. Exchanges of real property will be considered of a like-kind regardless of whether the properties are used for similar purposes.
Title A like-kind exchange requires the same taxpayer to be on both sides of the transaction. Accordingly, title to the Relinquished Property and the Replacement Property must mirror one another.
Timing A taxpayer is not required to simultaneously swap the Relinquished Property and the Replacement Property. Rather, a taxpayer has up-to 45 days to identify the Replacement Property. A taxpayer may identify 3 properties for the Replacement Property without concern to value. The taxpayer may identify more than 3 properties, but the total value of such properties may not exceed 200% of the value of the Relinquished Property. The entire transaction must be completed within 180 days from the closing of the Relinquished Property.
Qualified Intermediary Except in rare circumstances where a taxpayer simultaneously swaps the Relinquished Property for the Replacement Property, the IRC prohibits the taxpayer from completing a like-kind exchange through a direct transfer. In most cases, the exchange must be completed through an un-related third-party who facilitates the transaction, known as qualified intermediary. A qualified intermediary can acquire and transfer title for both the Relinquished Property and the Replacement Property to avoid the taxpayer partaking in a direct transfer.
As with any tax-related transaction, timing is essential. Deadlines associated with the transaction have only ever been extended by the Federal Government twice, first as a result of the terror attacks of 9/11 and second during the COVID-19 pandemic. Failure to adhere to the timing will result in a taxable event, rendering void all of the work and expense incurred. Contact the attorneys at Stock and Leader, LLP for more information and assistance with completing your 1031 tax deferred exchange.