Like-Kind Exchanges under IRC §1031 Part I: Background and Rationale

Like-kind exchanges, a hot topic in today’s tax reform arena, actually originated hundreds of years ago — farmers would trade land for land, exchange livestock for livestock. If a piece of land or a cow or a horse was deemed more valuable than that which was received in return, the farmer would ask for something else to balance the exchange, such as food, a weapon, a tool, or money. The additional item or items were called “boot”.

Common practice becomes law

Like-kind exchanges were incorporated into the Revenue Act of 1921 as part of the extensive tax reduction package that included the repeal of wartime excess profits and preferential treatment for capital gains. 26 U.S. Code 1031 recognizes that an exchange of property that is being held for productive use or investment does not change one’s economic position-the value has simply been moved to another item or location. The rationale of the law is that to compel a taxpayer to pay taxes triggered by that transaction without the cash or economic gain to do so would be unjust, and that delaying imposition of the tax would stimulate economic activity through increased investment. IRC 1031 therefore defers the tax obligation until the replacement property is sold (unless it is later exchanged for another investment of like-kind).

For many decades, 1031 exchanges took place in just one day. The 1979 Starker decision, however, changed that. In Starker v. United States, the Ninth Circuit Court of Appeals ruled that taxpayers should still be covered by section 1031 in the event of a delay in the closing of the replacement property.

Today’s 1031 Like-Kind Exchanges

IRC 1031 states that a taxpayer will have no gain or loss recognized on an exchange of property that is held for productive use in a trade or business, or property that is held for investment, if such property is exchanged solely for property of like-kind which is also to be held for productive use in a trade or business or for investment.

1031 will apply if all of the following requirements are met:

  1. Both the property to be relinquished and the property to be acquired must be like-kind (more on this in Part II of this series)
  2. Both the property to be relinquished and the property to be acquired must be held for business or investment purposes
  3. The transaction must be structured so that the taxpayer does not actually or constructively receive the proceeds of the sale (see the 1991 Regulations, which among other things require that a “qualified intermediary” be used for non-simultaneous exchanges (aka “Delayed”, or “Starker” Exchanges)
  4. The replacement property must be identified within 45 days of the sale and must be acquired within 180 days of the sale. Note that the IRS is very strict in not allowing any extensions of these time limitations.

The new property acquired in the exchange takes the basis of the old property, adjusted by the value of any “boot” (the money or the fair market value of other property received or given in the exchange).  The boot itself is taxable to the extent of gain realized, at a normal capital gains rate.

Our law firm can help you minimize your tax liabilities

The tax law firm of Moskowitz, LLP assist clients with a wide range of tax issues, including tax planning advice in how to minimize the impact of federal and state income taxes. Contact our San Francisco office today for a consultation.

Our next post in this series will cover what qualifies as property of “like-kind.”