Like-Kind Exchanges Provide Tax Deferral Opportunities
Author: Scott Humphrey
A like-kind exchange under Internal Revenue Code (IRC) Section 1031, or 1031 exchange, received a lot of attention during the past election as President Donald Trump used this tax strategy in building his real estate portfolio. The attention to the tax-favorable law has declined since the election, but it appears the law will survive tax reform for exchanges involving real property.
Let’s start with defining a like-kind exchange. Essentially, it’s a tax-deferred swap of property that is of like-kind. To further illustrate, here’s a basic example. Hailey, an aspiring 7-year-old real estate mogul, owns a doll house that she’s currently renting out to some rather expensive dolls. Like any opportunistic developer, she’s selling this property at the market’s peak. While she’d like to sell this property, she’s interested in using the proceeds to buy a dilapidated star base for redevelopment. If she were to sell the doll house without performing a like-kind exchange, she’d have the following result:
If Hailey were to discuss this transaction with her tax advisor—or father—she’d receive help with structuring the deal as a like-kind exchange. In doing so, she could defer the $600 gain, but would reduce the tax basis in the star base equal to the amount of deferred gain on the sale.
To accomplish this transaction, there are a few hurdles Hailey would have to overcome. The first is that the property would have to be of like-kind. The definition of like-kind is rather broad, but in the example above you could exchange residential property for commercial property.
The second step is that replacement property should be identified within 45 days of relinquishing or selling the old property. Per IRS regulations, this identification should be made in writing and submitted to the person you’re buying the property from, qualified intermediary, escrow agent or title company.
The third step requires the replacement property be received by the earlier of 180 days after the sale of the original property or the due date of the seller’s return (including properly applied-for extensions).
The fourth and final step is the most important and the one most people understand. For the exchange to occur, the seller can’t have actual or constructive receipt of the proceeds of the sale (or other property) between the sale and purchase of the replacement property. In general, a like-kind exchange would require a qualified intermediary to facilitate the transaction. There are groups that perform these services, but you’ll need to make this decision by the time you sell the property. You cannot sell the property, receive the cash and then decide you want to conduct a like-kind exchange. At that point, it’s too late, as you have already received the proceeds.
A properly executed like-kind exchange can be a beneficial tax planning opportunity and should be considered when structuring sales and purchases. Next month, we’ll explore how to use a reverse like-kind exchange for when you know what property you want to buy or build, but haven’t yet sold one of your existing properties.
If you have any questions about like-kind exchanges and how they may affect you or your company, please contact Scott or your trusted BKD advisor.