CONSTRUCTION Accounting ARTICLE -
Sec. 1031 exchange and your construction company
Target Audience: Construction Industry Professionals, Business Owners, Contractors, Construction Accountants
In the course of dealing with real estate developers or property owners, you may have heard the term “Section 1031 exchange” or “like-kind exchange.” Both refer to the swapping of two properties, potentially resulting in a significant tax advantage — deferring gain until the replacement property is sold. What you may not know is that, under Sec. 1031 of the Internal Revenue Code (IRC), you may swap more than just real estate.
Sec. 1031 exchange ground rules
To qualify for the tax deferral of a Sec. 1031 exchange, you’ll naturally need to follow some IRS ground rules. For starters, the swapped properties must be of a like kind — in other words, real estate must be exchanged for real estate and equipment must be exchanged for equipment.
Also, there must be an actual exchange, rather than a sale (though cash can change hands), and the properties must be used in business or held for investment. They can’t, however, be stock held for investment or inventory. Last, the exchange must be completed within specified timeframes (more on this below).
Business-related swaps can involve more than two parties, and it’s permissible to include both real and personal property. The property doesn’t even have to exist at the time of the exchange.
Timeframe of a Sec. 1031 exchange
As mentioned, to succeed from a tax perspective, the timeframe in which the Sec. 1031 exchange occurs is critical. You aren’t required to exchange property simultaneously, but there are strict time limits for trade completion.
First, you must identify the property you’ll receive within 45 days after you close on the property you’re trading. So if you’re trading an inventory storage facility for a newer one closer to the area of most of your projects, you have 45 days to designate in writing where the new facility will be. In the case of equipment, you’ll need to provide specific identification of the asset in question.
Another timing rule relates to receipt of the chosen replacement property. Said property must be in your possession either within 180 days after you transfer your original property or by the date the relinquishing party’s tax return is due for the taxable year — whichever is earlier.
Thus, for instance, if you receive the property 120 days after the transfer date but three days after the relinquishing party’s taxes were due, you can’t consider the transaction a Sec. 1031 exchange. If it’s impossible to complete the exchange before the tax due date, the relinquishing party can request an automatic extension. But you still can’t exceed the 180-day limit.
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All about the boot in a 1031 exchange
Some exchanges may call for the inclusion of non-like-kind property. For example, you might wish to obtain a new bulldozer. In this case, you can pay the dealer some cash for the new one without losing the tax benefits of the Sec. 1031 exchange.
How would that work? Instead of trading your bulldozer in on a new model, you’d have to sell it to the dealer for its trade-in value and then buy your new bulldozer from the same dealer. Because the sale and purchase are reciprocal and mutually dependent, you may be able to treat the transaction as a Sec. 1031 exchange.
Bear in mind, however, that any cash involved is called “boot,” and the recipient must recognize it as gain to the extent there is gain. (From an accounting perspective, that gain would be of the same “character” as the underlying property.) But if there is depreciation recapture on the property, it would be recognized first.
Similarly, if any property you receive has assets (such as fixtures and equipment) that the property you trade doesn’t have, you may have to recognize gain to the extent of those assets as well.
Consult a construction accountant
The IRC rules for Sec. 1031 exchanges are complex and, as always, the IRS stands ready to challenge your transaction. Additionally, because capital gains rates may increase after 2010, you also need to consider how that may ultimately affect the tax consequences of a Sec. 1031 exchange. For these reasons, professional guidance from a construction accountant is a must.
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