Like-Kind Exchanges (also called tax-deferred exchanges or 1031 exchanges) are a great tool for tax planning and deferring taxable income. In practice, I have found that there is much confusion on when a like-kind exchange is a good idea and can be implemented effectively. Unfortunately, steps may have already been taken by the client which prevents the tax-deferred exchange by the time I hear about the transaction.
This article is focused on explaining what a like-kind exchange is and understanding when it can be used as a tax savings solution. Once you are able to identify that a like-kind exchange transaction is a solution for your tax situation, you can plan effectively and take the steps needed to implement the tax savings.
What is a like-kind exchange?
A like-kind exchange is a transaction or series of transactions that allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the sale of the first asset.
How does it work?
Generally, when you sell an asset, you must pay taxes on the difference between the purchase price and the sales price. This is known as the gain on the sale. There are very few exceptions which allow you to avoid paying the tax and the gain can be substantial. Think for instance if you bought a rental house 30 years ago. It’s likely that house has appreciated significantly in value. If you bought the house for $100,000 30 years ago and now the house is worth $500,000, the difference of $400,000 is the capital gain. This amount of gain can create a significant tax bill.
There could be many reasons why you would want to dispose of the property. Maybe you feel the investment strategy of the property has changed and you need to dispose of the property. Maybe you want to rent commercial property instead of an apartment complex. Either way, incurring the gain can be a deterrent. A like-kind exchange allows you to sell the property and purchase similar property without recognizing the gain and the tax bill that comes with it.
What is similar property?
The IRS defines similar property as “similar in nature or class.” Here are a few examples of what you can and can’t do.
- Almost all types of real estate property are considered similar property. Residential real estate is similar to vacant land. Commercial property is similar to residential property, and so on.
- Personal property (property that can be moved) can be exchanged but the rules are stricter. For example, one car can be exchanged for another car but a car cannot be exchanged for a truck
- Certain property does not qualify for exchanges such as inventory, personal residences, stocks and partnership interests.
What characteristics make an exchange the right decision for me?
First off, a like-kind exchange should only be used if you are deferring a significant amount of taxable gain. There are costs associated with effectively completing a like-kind exchange so deferring a small amount of gain, for instance $10,000, may not be cost efficient.
If you still want to be involved in managing property for a long period of time, a like-kind exchange may be right for you. Incurring the costs with a like-kind exchange may not be a good idea if you are looking to dispose of the property shortly after.
Also, properties that aren’t highly leveraged can make like-kind exchanges easier to complete. If you are relieved of debt in an exchanged, it is considered “boot” and is a taxable transaction.
What are the first steps I should take to start a like-kind exchange?
- The most important first step before doing ANYTHING is talk to your CPA. Like-Kind Exchanges can be very complicated and getting into more detail to start planning your exchange is the first step.
- Once you and your CPA agree that you qualify for an exchange, get a recommendation for a Qualified Intermediary “QI”. A qualified intermediary is required in a like-kind exchange transaction because YOU CANNOT TOUCH THE CASH. Taking the cash before the exchange is complete will disqualify you from receiving tax-deferred gain treatment. A QI will assist you in completing the exchange properly and set up an escrow for the exchange proceeds. This step is why planning is so important because I see clients in practice that want to defer the taxable gain but have already made the property sale and received the sale proceeds before they talked to their CPA.
- Look for an attorney that is familiar with like-kind exchanges. If you are utilizing an attorney for a real estate transaction, use an attorney that understands like-kind exchanges and how they are utilized for tax savings.
Like-Kind Exchanges are an amazing tax-deferral tool that can be utilized for your property. Careful planning and guidance are needed to ensure that the exchange is implemented successfully.