Like-Kind Exchange Basics

A like-kind exchange is possible when you buy and sell properties that are held for investment or business purposes. The technique cannot be used when selling your personal residence. Although personal property such as cars and airplanes can be exchanged, this chapter will stick to reviewing the exchange of real-estate properties. The advice offered here is a good start, and it is not intended to replace legal advice. You should contact a real-estate or tax attorney before you initiate any paperwork that involves buying and selling investment property you wish to include in a like-kind exchange.

During an exchange, you'll become familiar with two terms. The relinquished property is the property you sell, and the replacement property is the new investment property.

Tax Deference

The first thing you need to understand about §1031 like-kind exchange is that it does not eliminate the gains tax due on the sale — it only postpones it. If you ever decide to cash out of your investments, your taxes will be computed on the final, accumulated basis and sales amount. The deferment is like getting an interest-free loan on the tax dollars you would have owed on a cash sale.

You should talk with a tax professional to determine the amount of gain that will be deferred in a transaction, but there are a few basic guidelines to keep in mind:

  • The fair market value of the replacement property must be equal to or greater than the fair market value of the relinquished property.

  • The equity you have in the replacement property should be equal to or greater than the equity you had in the relinquished property.

  • If you trade down in equity or fair market value, you will be taxed on the difference.

If, in addition to like-kind property, you receive money or unlike property in an exchange on which you realize a gain, you have a partially taxable exchange. You are taxed on the gain you realize, but only to the extent of the money and the fair market value of the unlike property you receive.

What Are Like-Kind Properties?

Another requirement is that the exchanged properties must be like-kind. That term is a little confusing because it doesn't mean you have to exchange an office building for another office building, a duplex for a duplex, or a piece of land for another piece of land. Any real property is considered like-kind when compared with another real-estate property.

To be eligible, the relinquished and replacement properties must be properties held for investment purposes or for use in a trade or business. This includes the following:

  • Rental houses and buildings, raw land, industrial property, farms, and office buildings

  • A vacation home used as a rental

  • A real-estate lease that runs for longer than thirty years

Real estate held as inventory for sale is not eligible for exchange. Neither does your personal residence or a vacation home that you personally use more than two weeks each year.

Real property in the United States and real property outside of the United States are not like-kind properties. The IRS defines foreign property as any property not located in a state or the District of Columbia.

Avoiding Receipt of Funds

If you actually or constructively receive money or unlike property in payment for the property you transfer, the IRS will treat the transaction as a sale, not a deferred exchange. Constructive receipt occurs when money or unlike property is either credited to you or available to you.

When you do a like-kind exchange, the proceeds from the sale are never in your possession and not available — you must sign away that right. The funds are held by a neutral party, called a qualified intermediary, facilitator, or accommodator, until a replacement property is acquired. The intermediary uses the money to purchase the replacement property, arranging for the title to be in your name.

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