The most significant change the Tax Cuts and Jobs Act (TCJA) brought to like-kind exchanges is that it is limited to only real property held for productive use in a trade or business or held for investment. Personal property is no longer eligible for gain deferral under Section 1031.
Like-Kind Exchange Options
Under the TCJA, taxpayers can exchange business or investment real property for other business or investment property under a like-kind exchange, deferring any gain on the replacement property until the property is sold. A basic like-kind exchange is recognized through the simultaneous swap of one property for another.
Taxpayers also have the option to elect a forward exchange or reverse exchange under Section 1031. In a forward exchange, the taxpayer can transfer property before receiving the replacement property. Conversely, in a reverse exchange the replaced property stays with an exchange accommodation titleholder until the transferred property is relinquished. An exchange accommodation titleholder holds the title to either the relinquished or replacement property until such time the relinquished property is transferred to the buyer.
What constitutes a like-kind exchange?
To claim a like-kind exchange exemption, the taxpayer must assume genuine ownership in the replaced property. Genuine ownership in the property is not defined by legal title; instead, the taxpayer must hold the benefits and burdens of property ownership.
Exchange Attempt Exemplified
The most significant impact businesses might see is concerning the trade-in of vehicles or equipment. For example, assume that a farmer wishes to buy a new tractor for $4,000. To pay for the tractor, the farmer trades in his old tractor, which has a tax basis of $0 (because it has been fully depreciated) and a trade-in value of $1,000 and gives the tractor dealer $3,000 cash. Under Section 1031 before January 1, 2018, the farmer would have recognized no gain on the disposition of his old tractor and would have a tax basis in his new tractor of $3,000. Because of the tax law changes, this same transaction results in the farmer recognizing $1,000 of gain on the disposition of his old tractor and a basis in his new tractor of $4,000
Although the gain can no longer be deferred, the new law adds a full expensing deduction that can be used to offset any capital gain or depreciation recapture recognized in the same or future years on tangible business use personal property, including heavy equipment, farm machinery and vehicles in the year that they are placed in service by the taxpayer. Full expensing is temporary and will expire in 2022, being reduced to 80% for assets placed in service in 2023 and will continue to be reduced each year after. The deduction applies to both new and used property acquired by the taxpayer.
Construct with care
Like-kind exchanges are a valuable tax tool, but they're not always as straightforward as they might seem. Consult with your financial advisor and attorneys to structure transactions that withstand IRS and judicial scrutiny.