People who own real estate within their business or for investments often find themselves holding significantly appreciated assets. While that’s normally a good thing, people are still surprised at the tax bills that could result when they sell their properties. Consequently, it’s important that people who subsequently replace that property or acquire new property not miss out on a key provision of tax law.
Whenever you sell a business or investment property and realize a gain, you generally have to pay tax on the gain at the time of sale. The IRS provides one exception that allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. This type of transaction is also known as a tax-free exchange, Starker exchange or 1031 exchange.
By participating in a like-kind exchange, you can acquire property that’s more suitable for your business without paying tax on the gain. The gain on the exchange is effectively deferred until you sell or otherwise dispose of the property you receive. This type of tax-deferred transaction is allowed because your economic position remains the same since you have merely exchanged one property for another. You will, however, have to recognize gain on any money or unlike property you receive in the exchange.
Before you decide to engage in a like-kind exchange, there are a few things you want to consider. It’s important to understand the types of property that qualify, the timing requirements and consequences when non-like-kind property is involved.
To qualify for like-kind treatment, both the property you give up and property you receive must be used in your trade or business or held for investment purposes. Property used primarily for personal use — a primary residence, second home or vacation home — doesn’t qualify for like-kind exchange treatment. Like-kind property is defined as property of the same nature, character or class. Quality or grade doesn’t matter. Therefore, the exchange of improved real estate for unimproved real estate can qualify as like-kind. One exception for real estate is that property within the United States can’t be exchanged for property outside of the United States.
Real property and personal property can both qualify as like-kind exchange properties. But real property can never be exchanged for personal property and vice-versa. Buildings, rental houses, land, trucks and machinery are examples of property that could qualify. Certain types of property are specifically excluded from like-kind treatment, including inventory or stock trades; stocks, bonds or notes; other securities or debt; partnership interests; and certificates of trust.
The total purchase price of the property to be acquired must be equal to or greater than the total net sales price of the property being relinquished, and all equity received from the transaction must be used to acquire the new property.
While a like-kind exchange doesn’t have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These time limits can’t be extended for any circumstance or hardship except in the case of presidentially declared disasters. The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be clearly described in writing, signed by you and delivered to a person involved in the exchange — the seller of the replacement property or qualified intermediary, for example. In the case of real estate, it’s recommended to include a legal description and street address. The second limit is that replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or due date, including extensions, of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.
It’s important to know that taking control of cash or other proceeds before the exchange is complete could disqualify the entire transaction from like-kind treatment and make all gain immediately taxable. One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary to hold the proceeds until the exchange is complete. If cash or other proceeds that are not like-kind are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange, but gain may be taxable to the extent of the proceeds that are not like-kind.
Remember, too, that like-kind exchanges result in tax deferral, not tax elimination. When the replacement property is ultimately sold, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Like-kind exchanges offer a great way to defer paying tax. But every situation is different. Consult with an experienced real estate professional and an accountant to discuss the best options for you.