Tax-Free Magic Tricks: Like-Kind Exchanges
What is this all about? In essence, like-kind exchanges allow for tax deferral on big gains, for a very, very long time. Good, yes?
But actually, like-kind exchanges are not simple.
So this is a reference guide, for your convenience. This helps with your understanding the rules, if you ever need to. Or maybe better, let your CPA understand. You’re busy enough already …
What are the Simplified Rules for a Tax-Free, Like-Kind Exchange?
If you could sell your property for a gain, the Internal Revenue Code Section 1031 allows you to postpone paying tax on that gain. The requirement, you have to be willing to reinvest the proceeds into a similar property. If you meet all the rules under §1031, this transaction would qualify as a like-kind exchange.
Even though the requirements under IRC §1031 (actually, 26 United States Code §1031) are numerous and technically detailed, there are a few simple basics that you should understand:
- Who qualifies for the Section 1031 exchange? Basically, any person or taxpaying entity can make an exchange of business or investment properties for other business or investment properties.
- Is there a specific structure for a 1031 Exchange? The simplest and by far the most common §1031 exchange is a simultaneous swap of one property for another. There are also “deferred exchanges”, which are more complex but also more flexible. These deferred exchanges allow you to relinquish one property now, and then later find and acquire replacement property. Those who choose to have deferred exchanges generally hire and use a third-party, called an “exchange facilitator”. And there are variations to the deferred exchange. The rules are painfully detailed in the U.S. Treasury Regulations.
- Does all property qualify? Both properties (or sets of properties) must be for use in business or for investment. Property that is mostly for personal use (ie: personal residence, vacation home, etc.) will not qualify. Also, both properties must be similar enough in their nature, character or class to qualify as "like-kind." But here’s a good tip: nearly all real estate will be “like-kind” to other real estate, even if one is a single family house in Springfield, Illinois and the other is a vacant lot in Springfield, South Carolina, as long as both are within the United States.
For exchanges of personal property (i.e.: cars or trucks, office machines, heavy equipment) the rules for what qualifies as like-kind are more complex and restrictive. Think about this: cars are not “like-kind” assets to trucks.
Also, certain specific property types no not qualify, including: Inventory or stock in trade, commercial or financial paper (stocks, bonds, or notes, financial securities or debt), partnership interests, or certificates of trust.
- There are two basic time limits to the §1031 exchange. Each begins with the date the original property was disposed. These time limits are very strict. There are few exceptions, no extensions, and no grace periods.
The first is the 45-day identification period. Basically, you have 45 days from the date you relinquish the initial property until you identify the (potential) replacement property. The rules require this identification to be quite formal, meaning: in writing, signed by you, and delivered to the seller of the replacement property. If you use a “qualified intermediary”, notice can be made to and through that person. Also, within that written notice of identification, the replacement property must be clearly described (by address, legal description, vehicle identification numbers, etc.).
The second limit is the replacement deadline. In most cases, this gives you 180 days to complete the exchange for the replacement property. (Again, in most cases.) Obviously, the new (replacement) property actually received has to be the same property identified during the earlier 45-day period.
- What if there’s cash proceeds left over? That is another discussion, with abundant details. But you should know, if you take cash out of the deal before it’s all done, the tax-free part will probably fail.
But these are just some general rules. Again, the Tax Code language and the Treasury Regulations are explicitly detailed with lots of examples, exceptions, and special requirements. Admittedly, it’s a hard read. (Trust me.) I would recommend to anyone interested to hire a Qualified Intermediary to facilitate the transaction.
And if IRS ever challenges the transaction, at that point, you will need a Tax Defense Attorney.
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