Impact of the Tax Cuts and Jobs Act on Like Kind Exchanges (IRC 1031)
The Tax Cuts and Jobs Act (“TCJA”) retained the ability for taxpayers to defer gains on the sale of appreciated real estate through the use of “like-kind” exchanges under IRC section 1031. The TCJA eliminated, however, the availability of like-kind exchanges of personal property.
Starting Jan 1, 2018, all personal property and intangible assets (such as aircraft, autos, trucks, heavy equipment, farm machinery, livestock (all types), artwork, collectibles and intangibles like fast-food restaurant franchise licenses) will no longer qualify for Section 1031 tax-deferral treatment. Exchanges of personal property assets that were in process in 2017 will qualify only if:
- the exchange was entered into before 2017 year-end; and
- either the relinquished property has been sold OR the replacement property has been acquired by the taxpayer by 12/31/17.
In general, exchanges that involve real estate held for investment or for productive use in a trade or business (and not held primarily for sale) have not been affected by the TCJA. Partial interests in real estate remain eligible for like kind exchange treatment. This includes tenants in common and other forms of undivided fractional interests; remainder interests; life estates; leaseholds of longer than 30 years; perpetual water rights; coal and oil leases; royalty interests in oil, gas property; mineral interests.
Mutual ditch or irrigation companies remain eligible for like-kind exchange treatment so long as the company is treated as exempt from income tax under 501(c)(12)(A). Real property located outside of the U.S. will not qualify as real property of a like kind for 1031 purposes.
One change, however, may impact like kind exchanges of partnership real estate. In the past, the IRS recognized a partnership as a single entity for purposes of like kind exchanges. A partnership could exchange the real estate owned by the partnership, but the individual partners who made up the partnership could not exchange their individual partnership shares. This created a problem when one or more partners wanted to move out of the partnership and go on their own without paying capital gains tax.
In order to accomplish a like-kind exchange, a common technique was to do a “drop and swap” where the partnership interest was converted into tenants in common ownership prior to the exchange. Under such an arrangement, each owner was considered to then hold the equivalent of a separate piece of real estate, allowing them to trade that piece for another property of their own.
Under a new provision of the TCJA, if a partnership elects under 761(a) to not be treated as a partnership, the interests held by the partners are then deemed to be held directly in the real estate owned by the partnership (as well as its other assets), rather than owned by the partnership for 1031 purposes.
In some circumstances, this may provide an alternative to the “TIC” drop and swap arrangements, in that it would seem to allow the individual partners to do an exchange of certain forms of individual partnership interests. This election was available pre-TCJA, but it was not clear whether it was sufficient by itself (without actually changing record title) to work for like kind exchange purposes.
IRC Code section 761(a) allows the partners of a tax partnership to elect out of Subchapter K, by reporting the income on their individual Form 1040 tax returns, but it only applies to partnerships owning investments that have specific attributes. The partnership entity remains a partnership entity for purposes of the limitation on allowable credits and other tax attributes.
To qualify, the partners and the partnership must meet the following conditions:
- The group has chosen to be treated as a partnership pursuant to its state’s partnership laws and has filed partnership returns in prior years.
- The group has limited involvement in the property’s operation. For example, undeveloped land may be an optimal asset in this respect.
- Few, if any, restrictions otherwise exist on the co-owners’ rights to sell their interests individually.
- No provisions of the partnership agreement require a majority vote to transfer the asset.
- Each owner has been allocated a constant pro rata share of income and loss based on its share.
These requirements may be difficult to satisfy for closely-held partnerships and LLCs with buy-sell arrangements.