Section 1031 exchanges are not new. But the rules have changed over time.
A Section 1031 or like-kind exchange is an income tax concept. It applies when you swap two real estate properties with the same nature or character. Even if the quality or grade of these properties differs, they may still qualify for like-kind exchange treatment.
Personal Property Not Qualified for Like-Kind Exchange
Before we start, we should pause to note the new 1031 rules. The Tax Cuts and Jobs Act made some changes to the Section 1031 exchange rules. Personal property and intangible property will no longer qualify for a like-kind exchange. Moreover, you can’t use real properties held for sale for a like-kind exchange only investment properties.
Since the new 1031 exchange rules no longer allow the exchange of personal property, you don’t have to worry about accumulated depreciation (land is not depreciable–the Section 1031 exchange only applies to land–not buildings or structural components that are situated on the land). However, for accounting purposes, you have to recognize Gain or Loss on Exchange when you complete the transaction.
Now let’s look at how to record the 1031 exchange for accounting and income tax purposes.
Accounting vs. Income Tax Reporting
For income tax purposes, you will not recognize a gain or loss on the exchange until you sell it the newly acquired property. But this treatment only applies to income tax reporting.
For accounting purposes, you need to recognize a gain on loss or exchange, if applicable. And, it will be one of the reconciling items you need to input on your tax return (see the Schedule M-1 Reconciliation of Income (Loss) per Books With Income per Return. for C corporations, for example).
The entry you need to make depends on the nature of the transaction.
If you don’t have a Gain or Loss account yet, you have to set up the account first before you do your journal entries.
Scenario 1: Value of Exchanged Property Equal to Fair Market Value of Property Received
Let’s consider an example. Assume you own a piece of land in California (valued at $100,000) and you enter into a like-kind exchange to acquire another property in Colorado (also valued at $100,000).
In a pure like-kind transaction like this, you can record the transaction as follows:
Debit: Land (new) $100,000
Credit: Land (old) $100,000
Since land is an asset account, a Debit to the account will increase the balance of the asset account. Hence, the need to debit the account for the value of the new property.
The credit to the land account for the value of the property you exchanged decreases the account and removes that account from your books.
Scenario 2: Value of Exchanged Property is More than the Fair Market Value of Property Received
Let’s change up the example a bit.
Now, what if the property in California valued at $100,000 and the land you want to acquire in Colorado through a like-kind exchange has a fair market value of $90,000?
In this case, you have to record a Loss of Exchange amounting to $10,000.
Land (new) $90,000
Loss on Exchange $10,000
Land (old) $100,000
If the value of the property you exchanged is higher than the value of what you received, you need to record a loss on your part.
Scenario 3: Value of Exchanged Property is Less than to Fair Market Value of Property Received
Here’s another scenario: the land you will give up has a value of $75,000 and you will receive a property worth $90,000.
In this case, you will record the entry as follows:
Land (new) $90,000
Land (old) $75,000
Gain on Exchange $15,000
The Gain on Exchange is the $15,000 difference between the land you received and the land you gave up.
If there are any closing costs or other expenses related to the exchange, record that in the debit side of the transaction.
Cash Boot on a Section 1031 Exchange
When you’re doing a 1031 exchange, you want to avoid receiving any kind of “boot.”
Boot is a tax term used to refer to cash or other property other than the like-kind property. It is an amount you receive or are deemed to receive because it does not qualify for Section 1031 treatment.
The boot you receive is taxable.
When you receive boot in a like-kind exchange, you need to record the additional consideration along with the entries above.
For instance, you give up property worth $50,000 and for a property worth $40,000 and a cash boot of $10,000.
You can record this transaction with the following entry:
Land (new) $40,000
Cash $ 10,000
Loss on Exchange $10,000
Land (old) $50,000
The $10,000 difference will be a debit to a Loss on Exchange account since the total value of the items you received is less than what you gave up.
If the scenario was reversed such as when the property you receive is greater than the value of what you gave up, you will record a gain on exchange.
Talk to Your Tax Accountant
Doing a like-kind exchange can have a lot of benefits. Aside from deferring capital gains tax, you may be exempt from paying state mandatory withholding.
For tax reporting purposes, you need to report a like-kind exchange using Form 8824. The form itself can be confusing.
Tax reporting for a Section 1031 exchange can be tricky.
There are also deadlines that you need to meet and tax forms you may have to complete because of the. If you fail to submit those forms, you may not be eligible for capital gains tax deferral and there could be penalties and other expensive consequences.
Recording a like-kind exchange in your books is similar to recording the sale of your property. So, it should not give you much trouble. However, we strongly suggest that you consult your tax adviser if you’re planning to do a 1031 exchange.