Wouldn’t it be great to sell your investment property and replace it with a better piece of property, without having to pay taxes on the gain from the sale? Well you can. One way to do this is a “like kind exchange,” which may not be an exchange at all. When you make a like-kind exchange, you are not currently taxed on resulting gain. As long as you do not receive cash or other nonqualifying property, any gain is postponed.
One dangerous myth is that you can sell a property, receive the proceeds and later reinvest the proceeds in a like property, tax-free. Wrong! This type of sale does not qualify as a like-kind exchange. It is taxable.
In this article, I will call the party who is getting rid of a property the “exchanging party.” The property you give up is called the “relinquished property.” The property you acquire is the “replacement property”. Here is a summary of the requirements to qualify for a like-kind exchange.
1. The relinquished property and the replacement property must both be held for business or investment purposes.
2. Property held primarily for sale or for personal use does not qualify as replacement property.
3. In a real estate exchange, personal property and cash do not qualify as replacement property.
4. If the transfers are not simultaneous, the transfer may qualify if the taxpayer follows strict identification rules and time limits for closing on the replacement property.
If you receive nonqualifying property or cash (called boot) in addition to like-kind property, the exchange can qualify, but the boot triggers taxable gain in an amount up to the boot’s value. Furthermore, if the property you relinquish is mortgaged, you are treated as if you received cash (boot) equal to the amount of the debt you get out of.
Example: if in an exchange you receive besides property a vintage Mercedes worth $35,000. You must report taxable gain of $35,000.
As I said earlier, gain from a like-kind exchange is taxable, but taxed later. The delay is accomplished by substituting your basis (cost) in the relinquished property for your basis in the replacement property received. So if your relinquished property has a $100,000 basis, the basis of the replacement property is $100,000. This basis is called carryover basis.
If you receive taxable boot, the replacement property’s basis decreases by the amount of cash boot but increases by gain you report. If you pay cash or transfer other boot in addition to the relinquished property, the replacement property’s substituted basis increases by the value of the boot. This is getting simple, right?
If you sell first and replace later, it can be a qualifying exchange, but things get more complicated. You must transfer the relinquished property to a “qualified” intermediary. The “qualified” intermediary may sell the relinquished property and use the cash to buy a replacement property from a third party and then transfer it to exchanging party. If the exchanges are not simultaneous, the exchanging party must identify the replacement property within 45 days after the closing of the sale of the relinquished property. You must close on the purchase of the replacement property within 180 days after the earlier of the transfer of the relinquished property or the timely filing of your tax return. Guaranties and other security arrangements can blow the deal. If you or your agent receives any cash from the sale of the relinquished property, the IRS may treat you as if you received the cash. Agents include your employee, attorney, accountant, investment banker, broker, real estate agent or broker. The “qualified” intermediary cannot be your agent (closing attorney, accountant, etc.).
The IRS enforces these rules strictly. One common thread in these rules limits the exchanging party’s access to the proceeds from the sale of the replacement property. Multiple or alternative replacement properties are allowed but there are more rules. The best way to reduce your risk is to work with a professional and use a contract that locks in compliance with the safe harbors.
Caveat: If you are considering a 1031 transaction, make sure you have proper tax and exchange advice.