Like-Kind Exchanges

If you are holding on to appreciated real property because you don't want to pay capital gains taxes, a like-kind exchange may be the answer. The IRS allows you to defer gains on property if you exchange it for property of the same nature or character.

Most exchanges of real property can be considered like-kind exchanges, as long as neither property qualifies as your residence. For example, you could exchange farmland for an apartment building of equal or greater value without recognizing any gain at that time. Your basis in the new property is reduced by the amount of deferred gain, as shown in the example.

Example

Bob purchased a parcel of land for $50,000 in 1997. Today, the land is worth $75,000. He wants to dispose of it and buy a new piece of land worth $100,000. If Bob sells the land and pays the $75,000 plus an additional $25,000 for the new land, this would be his tax situation:

 

Sale and Purchase

Sale price of farmland

$75,000

Less basis in land

(50,000)

Gain on sale of farmland

25,000

Tax rate

X   20%

Current year tax liability

$ 5,000

 

 

Basis of newly acquired land

$100,000

However, if Bob does a like-kind exchange and trades his old land and $25,000 in cash for the new parcel of land, it would result in the following

 

Like-Kind Exchange

Sale price of farmland

$ 75,000

Less basis in land

(50,000)

Gain on sale of farmland

25,000

Gain deferred

(25,000)

Current year recognized gain

0

Cost of acquired property

$100,000

Less: deferred gain

(25,000)

Basis of newly acquired land

$ 75,000

The like-kind exchange gives Bob an additional $5,000 in his pocket. If Bob received property of a like kind plus cash and/or other property in an exchange, he would only have to recognize a gain up to the value of the other property received. Any remaining gain would be considered as generated by the like-kind exchange.

Creative Transactions

What if the owner of the land didn't want Bob's land in exchange? If Bob had a buyer for the farmland, he could arrange a three-party transaction that would still qualify as a like-kind exchange if performed properly. Bob would first transfer the title of the farmland and the cash to the facilitator. The facilitator would then sell the farmland, purchase the new land, and transfer the title of the new land to Bob.

Do not attempt a creative like-kind exchange arrangement without consulting a professional. There are special rules about who can qualify as a facilitator in this situation, and timing is critical.

New Rules and Benefits

Like-kind exchanges provide even more benefits after recent changes in the depreciation rules. Previously, depreciation on the entire amount of basis in the new property would start over. For exchanges occurring after January 3, 2000, the portion of the basis in the new property attributable to the remaining basis in the old property will continue to be depreciated as if the property was never disposed of. This will often result in faster depreciation than under the old rules.

Drawbacks

Like-kind exchanges allow you to defer gain on an exchange, but you must also defer any loss on the exchange. Therefore, it may be wiser to sell properties where the fair market value is less than its undepreciated basis, as in the case of an automobile trade-in.

The like-kind exchange is a powerful tool for minimizing taxes, but planning and executing such an exchange is a complicated and delicate process. If you own property and are considering a like-kind exchange, consult a financial professional before moving forward.

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