As a real-estate investor, you may want to unload one property and replace it with another. But selling an appreciated property results in a current tax hit. This is a bad outcome if you intend to use the sales proceeds to buy replacement property.
The good news: Section 1031 of the Internal Revenue Code allows you to postpone your tax bill by arranging for a deferred like-kind exchange. This time-honored maneuver is one big reason that some real-estate investors have struck it rich. However, there’s a risk that the like-exchange privilege could be sacrificed at the altar of tax reform. So it could be a good idea to get like-kind exchanges done sooner rather than later while the current taxpayer-payer friendly rules are still in place. Here’s what you need to know.
Like-kind exchange basics
You can arrange for tax-free real property swaps as long as the relinquished property (the property you unload in the swap) and the replacement property (the property you receive in the swap) are of like-kind.
To avoid any current taxable gain, however, you also must avoid receiving any “boot.” Boot means cash and property that’s dissimilar to the relinquished property. When mortgaged properties are involved, boot also includes the excess of the mortgage on the relinquished property (the debt you get rid of) over the mortgage on the replacement property (the debt you assume).
If you receive any boot, you are taxed currently on gain equal to the lesser of: (1) the value of the boot or (2) your overall gain on the transaction based on fair market values. So if you receive only a small amount of boot, your swap will still be mostly tax-free (as opposed to completely tax-free). On the other hand, if you receive lots of boot, you could have a big taxable gain.
Of course the easiest way to avoid receiving any boot is to swap a less-valuable property for a more-valuable property. That way, you’ll be paying boot rather than receiving it. Paying boot won’t trigger a taxable gain on your side of the deal.
In any case, the untaxed gain in a like-kind swap gets rolled over into the replacement property where it remains untaxed until you sell the replacement property in a taxable transaction.
What constitutes “like-kind” property?
When it comes to real estate, the IRS has a very liberal definition of “like-kind property.” So you can swap improved real estate for unimproved real estate, a strip center for an apartment building, a boat marina for a golf course, and so forth. However, you can’t swap real property for personal property without triggering taxable gain. For example, you can’t swap a building for an airplane. Finally, you can’t swap property held for personal use, such as your home or boat. Nor can you swap inventory, partnership interests, or investment securities. The vast majority of tax-free like-kind exchanges involve investment real estate.
Back in 2002, the IRS clarified that even undivided fractional ownership interests in real estate (like tenant-in-common ownership interests) can potentially qualify for like-kind swaps. For example, you need not receive an entire commercial building as the replacement property in order to complete your tax-free exchange. Instead, you could receive an undivided fractional ownership interest in the property.
Source: IRS Revenue Procedure 2002-22.
Deferred like-kind exchanges
As you might imagine, it’s usually difficult (if not impossible) for someone who wants to make a like-kind swap to locate another party who owns suitable replacement property and who also wants to make a like-kind swap rather than a cash sale. The saving grace is that deferred exchanges can also qualify for tax-free like-kind exchange treatment.
Under the deferred exchange rules, you need not make a direct and immediate swap of one property for another. Instead, you can in effect sell the relinquished property for cash, park the sales proceeds with an intermediary who effectively functions as your agent, locate a suitable replacement property later, and then arrange for a tax-free like-kind exchange by having the intermediary buy the property on your behalf. Here’s how a typical deferred swap works.
– You transfer the relinquished property (the property you want to swap) to a qualified exchange intermediary. The intermediary’s role is simply to facilitate a like-kind exchange for a fee which is usually based on a sliding scale according to the value of the deal. In percentage terms, intermediary fees are generally quite reasonable.
– Next the intermediary arranges for a cash sale of your relinquished property. The intermediary then holds the resulting cash sales proceeds on your behalf.
– The intermediary then uses the cash to buy suitable replacement property which you’ve identified and approved in advance.
– Finally, the intermediary transfers the replacement property to you to complete the like-kind exchange.
Voila! From your perspective, this series of transactions counts as a tax-free like-kind swap. Why? Because you wind up with like-kind replacement property without ever having actually seen the cash that greased the skids for the underlying transactions.
What if you still own the replacement property when you die? Under our current federal income tax rules, any taxable gain would be completely washed away thanks to another favorable provision that steps up the tax basis of a deceased person’s property to its date-of-death value. So taxable gains can be postponed indefinitely with like-kind swaps and then erased if you die while still owning the property. Wow! Real estate fortunes have been made in this fashion without sharing with Uncle Sam.
The last word
As you can see, like-kind swaps can get pretty complicated. However, the tax advantages can be huge, which makes all the complications well worth the trouble. That said, I don’t know if the current like-kind exchange rules and basis step-up on death rule will survive tax reform efforts — if anything actually becomes law. So doing like-kind swaps sooner rather than later may be advisable.
In order for your deferred exchange to qualify for tax-free swap treatment, you must meet two important requirements.
1. You must unambiguously identify the replacement property before the end of a 45-day identification period. The period commences when you transfer the relinquished property. You can satisfy the identification requirement by specifying the replacement property in a written and signed document given to the intermediary. In fact, that document can list up to three different properties that you would accept as suitable replacement property.
2. You must receive the replacement property before the end of the exchange period, which can be no more than 180 days. Like the identification period, the exchange period also commences when you transfer the relinquished property. The exchange period ends on the earlier of: (1) 180 days after the transfer or (2) the due date (including extensions) of your federal income tax return for the year that includes the transfer date. When your tax return due date would cut the exchange period to less than 180 days, you can simply extend your return. That restores the full 180-day period.