22 Aug 2022 Real Estate Like-Kind Exchange
Authored by Haynie & Company Senior Tax Manager Greg Ward, CPA
Taxes on Real Estate Sales
For taxpayers that invest in real estate or use real property in a business, gain recognition on the sale of that property can be a major concern. Sales generally force taxpayers to recognize value appreciation and incur a tax liability. A taxpayer may experience equity gains from holding the property while simultaneously reducing their cost basis in the property through depreciation expense each year. Whatever the case may be, all real estate owners should be aware of the opportunities available through like-kind exchanges and Section 1031.
What is a Like-Kind Exchange
The IRS allows taxpayers to defer the recognition of gain on investment or business real estate, as long as it is exchanged for property of a similar type. In place of recognizing a gain on the old parcel and treating the new property purchase as a fresh transaction, the taxable impacts of the two events are combined on a single form. The result is an adjustment to the cost basis of the new property. The taxpayer avoids the taxable event in the current year and accepts a reduced basis for depreciation going forward. This nonrecognition of gain benefit was also previously available for personal property beyond real estate (furniture, vehicles, etc.). That element of like-kind exchange was eliminated starting in 2018, leaving just the real estate option.
The “like-kind” test for parcels is interpreted broadly. Two pieces of property can be considered to have the same nature or character, even if they reflect different grades or valuations. Real estate can also be improved or unimproved and still pass this test. Multiple building parcels can be swapped for a single piece of land, or any combination thereof. Property can be sold and then acquired in a standard exchange, or the order can be inverted in a reverse exchange. Interests in real property held through a partnership can be exchanged for personally owned real estate.
Key disqualifying factors to consider:
- Domestic real property is not like-kind to foreign real property.
- Improvements that are conveyed without land are not like-kind to land.
- The taxpayer can never have access to the proceeds from the original sale, or the like-kind exchange will be invalid. The best practice is to employ a 3rd party exchange facilitator (Qualified Intermediary) that handles the closing transactions and cash custody on behalf of the taxpayer. The selection of a qualified and reputable Intermediary is crucial.
- There are time limits for the process. The replacement property must be identified within 45 days after the old property is sold. It must then be acquired within 180 days.
- Personal residences do not qualify unless there is a history of partial business use.
- The nonrecognition treatment does not extend to transactions that involve multiple asset categories. Any sale consideration outside of the like-kind real property categories (such as cash or a vehicle) is considered “boot” and creates a separate taxable event for the value involved. An example would be $20,000 in cash thrown in on top of a swap.
- Related party sales are generally not eligible for like-kind deferral. The IRS reviews these closely and requires an explanation for why the swap is not just a tax avoidance scheme.
The IRS recognizes that most real estate contains “incidental personal property” – standard items that typically transfer with real property (appliances, certain furniture, etc.). As long as the fair market value of this personal property does not exceed 15% of the fair market value of the replacement real estate, the inclusion of those items in the exchange will not lead to gain recognition.
Long-term Tax Benefits
Utilizing like-kind exchanges can allow for more impactful use of other tax benefits. For example, consider a taxpayer that has completed four like-kind exchanges, chained together over the years as their ownership has transferred from one property to the next. They have avoided gain recognition at four separate sale events in their lifetime, with each time further reducing the available cost basis in the newly purchased property. The taxpayer now holds the fourth parcel worth $750,000; due to previous exchanges and deferred gain amounts, their cost basis could be at or near $0. If the taxpayer sold the property, the taxable gain would be difficult to stomach – the full $750,000. However, if that taxpayer holds the property until death, their heirs will receive a “step-up” in cost basis to the fair market value as of the date of death. Effectively, no taxable gain will need to be recognized by any taxpayers for these four transactions if the heirs then promptly sell the property.
Like-kind exchanges provide a uniquely powerful deferral benefit that applies to the most valuable asset class. Given the large potential tax pitfalls associated with real estate transactions, we recommend checking with your CPA before proceeding with any like-kind exchange plans.
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