Taxpayers who exchange property for gains or losses usually report them as income or deductions on their tax returns in the year they exchanged the property. However, there are exceptions to this general rule. For like-kind exchanges, gain and loss are not recognized.
Like-Kind Exchanges Lawyers
What Is a Like-Kind Exchange?
In essence, a like-kind exchange is the exchange of property held for productive use in a trade or business or for investment for a property of “like-kind” for the same purpose. A property held for personal use (e.g., a residence) exchanged for a property for business use will not qualify.
The exchange of one business for another, or even one piece of tangible property, such as artwork or heavy equipment, could have been included until the passage of tax legislation in December 2017. A like-kind exchange applies only to the exchange of a business or real estate investment property.
How a Like-Kind Exchange Works
Investors must pay capital gains tax on profits earned from the sale of commercial or investment properties. If profits are made on a sale within one year of the initial purchase date, profits are taxed at the short-term capital gains rate, which ranges from 10% to 37%. If profits are made after one year, profits are taxed at the long-term rate, which ranges from 10% to 20%.
A qualifying like-kind exchange, however, exempts an investor from paying taxes on a gain if proceeds from the sale or disposal of the property are reinvested in a similar property of equal or greater value. Real estate is considered like-kind, except for one’s own personal residence. Any real estate property used in a trade or business or held as an investment qualifies for a like-kind exchange.
The first disposal will not be taxed when a taxpayer sells investment property and buys another within a stipulated period. In the case of a like-kind exchange, the tax payment will be deferred until after the sale or disposal of the second property.
In order to avoid creating a tax liability upon the sale of the first asset, a like-kind exchange must take several important considerations into account:
- A personal residence cannot be sold as an investment property.
- The asset purchased with the proceeds must be similar to the asset sold.
- You must use the proceeds from the sale of the first asset to purchase the other asset within 180 days of the sale of the first asset, although you must identify the asset within 45 days of the sale.
Before completing a like-kind exchange, make sure to check the latest tax rules about how much capital gain can be deferred.
Along with tax deferral, a like-kind exchange allows the seller to defer their depreciation recapture-the gain received from the sale of depreciable property that must be reported as income. Like-kind exchanges also allow taxpayers to avoid state taxes.
Some states require either the buyer or seller to pay state income taxes when they sell a property, known as mandatory state withholding. A like-kind exchange, however, may qualify for an exemption. The taxpayer must sign a state-provided exemption form or certificate to claim the exemption.
States may require the seller to submit the exemption form 20 days before closing, while others may allow it to be submitted at closing.
What Is Property of “Like-Kind”?
The tax law uses the term “Like-Kind” pretty broadly. “Like-kind” property is one that has the same nature or character as the property exchanged out by the taxpayer. Most real property is of “like-kind” to other real property.
A vacant lot is comparable to a 30-floor apartment building, for example. On the other hand, personal property is generally of “like-kind” to similar kinds of property, like a computer to a computer printer. However, a truck is not comparable to a computer.
The following properties are not considered “like-kind” by the law:
- United States real estate for foreign real estate
- Personal property primarily used within the United States for personal property primarily used outside the United States
- Animals of different sexes
- A stock in trade or other property held primarily for resale
- Stocks, bonds, or notes
- Other securities or evidence of indebtedness or interest
- Interest in a partnership
- Certificates of trust or beneficial interests
- Choses in actions (a right to receive or recover income, other consideration, or property from another)
What Are Some Benefits of Entering into a Like-Kind Exchange?
Taxpayers who exchange property at a gain benefit from like-kind exchanges in that no income is recognized at present. However, the gain that is not recognized will be used to lower the basis of the property received. As a result, the taxpayer may be taxed on the gain when they later sell the new property to another party.
A like-kind exchange can also be used to exchange non-depreciable property, such as land, for depreciable property, such as a building, and to generate depreciation expense deductions.
One of the biggest benefits of a like-kind exchange is its favorable tax treatment. Replacing an asset with a like-kind asset triggers no taxable event. Assets in the same asset class can be exchanged; they do not need to be identical.
The IRS does not limit the number of times one can perform a 1031 exchange. As a result, investors can continuously seek out more lucrative investment opportunities. In addition, the money that would have been used to pay capital gains taxes can be reinvested.
Although like-kind exchanges offer tax benefits, they are temporary. The tax burden is deferred, not eliminated. Capital gains taxes will be due at some point. The exchange will also become taxable if it does not occur within the prescribed period or according to IRS rules.
In the same way that capital gains taxes are deferred, losses are also deferred. Losses from like-kind exchanges must be carried forward.
- Capital gains tax deferral
- The ability to reinvest more money
- Exchanges are unlimited
What Is the Downside of Entering into a Like-Kind Exchange?
Gains and losses are not recognized when an exchange qualifies as a like-kind exchange. Therefore, if a taxpayer exchanged property at a loss, that loss may not be recognized and deducted.
Suppose the taxpayer later sells the property to an unrelated party for a lower price than the basis. In that case, the taxpayer can potentially deduct the loss from the basis of the property received.
- IRS regulations and rules are strict
- Deferred losses
- Tax obligations remain
What If I Paid or Received Cash Along With the Like-Kind Exchange?
A taxpayer who paid cash along with the exchange usually does not face any tax consequences. In contrast, the gain will generally be recognized as income if the taxpayer received cash with the exchange.
Do I Need an Attorney to Help Me With My Property Exchange or Tax-Related Problems?
Tax laws are complex and constantly changing. Although various tax preparation software on the market may help you with your tax problems, they cannot provide the same level of service that an experienced and knowledgeable tax attorney can.
Tax attorneys can assist you if you are unsure whether an exchange qualifies as a like-kind exchange or if you need tax representation before the IRS.
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