Like-Kind Exchanges Can Help You Defer Taxes on Gains
Using like-kind exchanges can help defer taxes on your investments, but there are a few pitfalls you should avoid in these transactions.
- Nov 16, 2011
By Shiv Kothari,
Tax Manager, Gumbiner Savett Inc.
A like-kind exchange is any exchange of property held for investment or for productive use in your trade or business for like-kind investment property or trade or business property. As long as the exchange is real estate (land and/or buildings) for real estate, or personalty (non-real estate) for similar personalty, it should qualify. However, exchanges of some types of property (for example, inventory, partnership interest or shares of stock), do not qualify.
Qualified Intermediaries: For a number of years, the IRS has allowed a deferred exchange through the use of qualified escrow accounts or qualified intermediaries. In a typical situation, the property is sold with a qualified intermediary receiving the proceeds. The intermediary then acquires replacement property you designate and transfers that property to you. The key to this transaction is that you cannot have control over the funds.
Timing Limitations: If the exchange is not simultaneous, you must identify the replacement property within 45 days after transferring the relinquished property and receive the replacement property within 180 days or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.
Boot: Frequently, however, the properties are not equal in value, so some cash or other non-like-kind property is tossed into the deal. This cash or other property is known as “boot.” If boot is involved, you will have to recognize your gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you get in the like-kind property you receive is equal to the basis you had in the property you gave up reduced by the amount of boot you received, but increased by the amount of gain recognized.
As an example: Smith exchanges land (investment property) with a basis of $2 million for a building (investment property) valued at $2.4 million plus $300,000 in cash. Smith’s realized gain on the exchange is $700,000: He received $2.7 million in value for an asset with a basis of $2 million. However, since it’s a like-kind exchange, he only has to recognize $300,000 of his gain on tax return, which is the amount of cash (boot) he received. Smith’s basis in his new building will be $2 million: his original basis in the land he gave up (the $2 million) plus the $300,000 gain recognized, minus the $300,000 boot received.
Note that no matter how much boot is received, you will never recognize more than your actual “realized” gain on the exchange. Even if you may not have to recognize any gain on the exchange, you still have to report the exchange on a tax return on Form 8824. Special rules apply to transactions between related parties.
Mortgage Debt: If the property you are exchanging is subject to debt from which you are being relieved, the amount of the debt is treated as boot. The theory is that if someone takes over your debt, it is equivalent to him giving you cash. Of course, if the property you are receiving is also subject to debt, then you are only treated as receiving boot to the extent of your “net debt relief,” which is the amount by which the debt you become free of exceeds the debt you pick up.
Like-kind exchanges are an excellent tax-deferred way to dispose of investment, trade or business assets. You should consult a tax advisor if you are interested in partaking in a like-kind exchange transaction.