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In the metro New York area’s expanding real estate market, investors are continuing to exchange properties. If the sale involves a large capital gain, defined as the profit from an investment, then the seller is normally liable for significant capital gains taxes. One way to limit tax liability from capital gains is to see if the transaction falls under the Internal Revenue Code’s Section 1031, a provision that provides for no capital gains tax when property is effectively sold in a like kind exchange.
What does the language of Section 1031 provide?
(a)Non recognition of gain or loss from exchanges solely in kind
(1) In general
No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.
What does this statute mean for real investors, tax professionals and other stakeholders in the real estate market?
It means that the exchange of “like-kind properties” within 45 days will not be subject to capital gains taxes. Here are a few terms that are necessary to the interpretation of this statute:
What is a 1031 like-kind exchange?
Under IRS regulations, a like-kind exchange applies only to the exchanges of real property that are held for use in a trade or business or investment. Ordinarily, a real estate investor who exchanges a real property for another like-kind property will be able to defer the payment of capital gains taxes.
What are like-kind transactions?
Like-kind transactions may involve the exchange of almost any type of real estate investment for any other type of real estate investment within the U.S. Residential property, commercial property, and even unimproved land may be exchanged in a like-kind transaction. For example, two parties might exchange one apartment building for another apartment building or for unimproved land or for a vacation home. The main limitation is that property held for personal use, such as one’s home, cannot be traded in like-kind transactions; the property must be held for use in trade, business, or investment.
Do “co-op” exchanges qualify as like-kind transactions pursuant to IRC 1031?
Yes, the IRS has ruled that co-ops are to be treated like real estate and can therefore be subject to tax deferral status. IRS private letter rulings allow for the mutual exchange of co-op stock to obtain tax deferred status. In addition, the New York Court of Appeals in State Tax Comm’n v. Shor, ruled that an interest in a co-op may be treated as an interest in real property.
What is Investment Property?
Investment property is any property that is used for a trade or business or for investment. It could be a storefront property or an apartment, or even a vacation home. However, investment property does not include real property held for personal use.
What is boot?
Boot is money used to supplement and/or balance out a property trade. For example, if two investors were to trade apartment complexes, but one complex was worth $1 million more than the other one, the recipient of the more valuable complex might pay the giving party an additional $1 million on top of the trade. Boot does not qualify as like-kind property under this tax-deferral provision, and some portion of this $1 million would be subject to capital gains taxes. Structuring a 1031 transaction to exclude boot should probably be done with the guidance of an experienced tax attorney or CPA.
What are the tax benefits for high income real estate investors in the New York City market and how would a 1031 transaction be calculated?
Real estate investors who buy and sell apartment buildings in hot areas like Brooklyn or Manhattan could defer the recognition of large capital gains. This could save them from paying hundreds of thousands of dollars in federal income taxes for passive income gain on the sale of real estate commonly known as capital gains income.
For example, a high income investor who bought an apartment building for $800,000 two years ago, that is now worth $1.8 million decides to sell it and use the proceeds to buy a like-kind property. If the investor sells the property for 1.8 million, the 1-million-dollar gain may be taxed at a 23.8 federal tax rate for a high-income investor who is in the top tax bracket (33-40 percent).
The one-million-dollar gain would net a tax bill of 23.8% equaling a federal income tax rate of 20% plus a 3.8% tax on New York State Net Investment Income, costing this investor an additional $238,000 of capital gains taxes that could be deferred or not reported as capital gains income under IRC 1031.
Have there be any recent changes to the IRS regulations for like-kind exchanges under IRC 1031?
Yes,effective January 1st of 2018, the IRS under the Trump Administration’s New Tax Cuts and Jobs Act specifically limited like-kind exchanges of property to real property and eliminated personal property from its provisions. That means that you can no longer do an exchange of machinery, sports cars, artwork collectibles, patents or other intellectual property as like-kind property as a tax-free swap.
What is Real property?
Real property is generally meant to include land, and anything built on it or attached to it.
Are there any exceptions to this rule prohibiting the exchange of personal property as like-kind property?
Yes, but only if the taxpayer had transferred their personal or intangible property before the effective date of December 31, 2017.
How do I apply or report 1031 Like-Kind exchange transactions to the IRS?
You have to file a form 8824 to determine the amount of taxable gain to report from the transfer of your property. Cash generated from a transaction may be considered to be boot if it is not considered to be of like-kind involved in the exchange. Due to the complexity of tax law regulations and letter rulings, and the complexities of the federal tax law, you might want to consult with your tax attorney or CPA on this issue before even considering reporting a 1031 transaction to the Internal Revenue Service.
Does the swapped property have to be exactly equal in value to the property previously sold or exchanged?
No, 1031 rules only suggest that the properties exchanged qualify as like-kind real estate properties and that they be roughly equal in value.
What does this mean for Real Estate Investors, Attorneys and Accountants?
It means that aggressive real estate investors should be looking for creative ways to avoid paying large amounts of capital gains taxes in the exchanges of real property in commercial real estate transactions. Investors should consult with their tax advisors, attorney’s and CPA’s in addition to reviewing the IRS regulations and private letter rulings and statutes that apply to like-kind exchanges.
Expert insight and analysis was provided by Pardalis & Nohavicka, LLP and Law Clerk Jacqueline Weiss. Jacqueline Weiss is a third year law student at Albany Law School. Ms. Weiss has completed New York State Basic Mediation Training for Community Mediation. She is currently an extern at the New York State Office of The Attorney General in its Litigation Bureau. During her first year of law school she was a judicial intern to Justice Pineda-Kirwan at the New York State Supreme Court of Queens County. She is interested in civil and commercial litigation.