Like-Kind Exchange Explained
A like-kind exchange is executed for one reason: to defer capital gains taxes. There are many rules and qualification requirements that you must comply with in order to perform a successful exchange, here’s what you need to know.
Like-Kind Exchange
The term Like-Kind Exchange is defined under section 1031 of the IRS Code. A Like-Kind Exchange allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained by the sale of the first property. Using a Like-Kind Exchange is basically swapping one property for another property of like-kind.
A like-kind exchange is executed for one reason: to defer capital gains taxes. There are many rules and qualification requirements that you must comply with in order to perform a successful exchange. The biggest advantage of using a Like-Kind Exchange is that you can avoid having to pay capital gains taxes on the sale of an investment property.
When you sell an investment property, even if you weren’t the one who initially purchased, you are liable to pay capital gains tax. If your property is worth more today than what you (or the original owner) purchased it for, you can benefit from using the Like-Kind Exchange. Using a Like-Kind Exchange lets an investor trade property without incurring a sudden tax obligation, if both the purchase price and the new loan amount are the same or higher on the replacement property.
4 Types of Exchanges
1 – Simultaneous Exchange: A simultaneous exchange occurs when the replacement property and relinquished property close on the same day. As the name suggests, these closings occur in a simultaneous fashion.
2 – Delayed Exchange: This occurs when the exchangor relinquishes the original property before he acquires replacement property. The property the Exchangor owns (“relinquished” property) is transferred first and the property the Exchangor wishes to exchange it for (“replacement” property) is acquired second. Using this strategy, an investor has a maximum of 45 days to identify the replacement property and 180 days to complete the sale of their property. Due to the extended timeframe, the delayed like-kind exchange is by far the most common type of exchange chosen by investors.
NOTE: The Exchangor is responsible for marketing the property, securing a buyer, and executing a sale and purchase agreement before the delayed exchange can be initiated. The Exchangor must hire a third-party Exchange Intermediary to initiate the sale of the relinquished property and hold the proceeds from the sale in a binding trust for up to 180 days while the seller acquires a like-kind property.
3 – Reverse Exchange: A reverse exchange occurs when you acquire a replacement property through an exchange accommodation titleholder before you identify the replacement property. In theory, this type of exchange is very simple: you buy first and you pay later.
The reverse exchange follows many of the same rules as the delayed exchange. However, there are a few key differences to note:
Taxpayers have 45 days to identify what property is going to be sold as “the relinquished property.”
After the initial 45 days, taxpayers have 135 days to complete the sale of the identified property and close out the reverse Like-Kind Exchange with the purchase of the replacement property
Reverse exchanges require all cash
Failure to close on the relinquished property during the 135-day period will result in a forfeit of the exchange
4 – Construction/Improvement Exchange: The construction exchange allows taxpayers to make improvements on the replacement property by using the exchange equity. The taxpayer can use their tax-deferred dollars to enhance the replacement property while it is placed in the hands of a qualified intermediary for the remainder of the 180-day period.
It is important that the taxpayer meets three requirements if they want to defer all the capital gains tax (from the sale of the relinquished property) by using it for construction or improvement to the replacement property.
The entire exchange equity must be spent on completed improvements or as down payment by the 180th day.
The taxpayer must receive “substantially the same property” that they identified by the 45th day.
The replacement property must be equal or greater in value when it is deeded back to the taxpayer. The improvements must be in place before the taxpayer can take the title back from the qualified intermediary.
Like-Kind Exchange Rules
Rule 1: Like-Kind Property
To qualify as a Like-Kind Exchange, the property being sold, and the property being acquired must be ***like-kind and must be within the U.S. to qualify under section 1031.
***Like-kind property means that both the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” You can not exchange farming equipment for an apartment building because they are not the same type asset. In terms of real estate, you can exchange almost any type of property, as long is it is NOT Personal Property.
Exchanging an apartment building for a duplex is allowed.
Exchanging a single-family rental property for a commercial office building is allowed
Exchanging a rental property or vacation rental for a restaurant space is allowed.
Starker Exchanges can include more than two properties. For example, you can exchange one property for multiple replacement properties and vice versa. Only if the new properties are like-kind to the original properties.
Rule 2: Investment or Business Property Only
A Like-Kind exchange is only applicable for investment or business property, not personal property. In other words, you can’t swap one primary residence for another.
For example:
If you moved from California to Texas, you could not exchange your primary residence in California for another primary residence in Texas.
If you were to get married, and move into the home of your partner, you could not exchange your current primary residence for a vacation property.
If you were to own a single-family rental property in Ohio, you could exchange it for a commercial rental property in California.
Rule 3: Greater or Equal Value
In order to completely avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax.
For example, you have a property worth $2,000,000, and a mortgage of $500,000. To receive the full benefit of the 1031, the new property (or properties) you purchase need to have a net worth of at least 2 million dollars, and you’ll have to carry over at least a $500,000 mortgage. It’s important to note that the $2,000,000+ value, and $500,000 mortgage, can go towards one apartment building or three different properties with a total value of $2,000,000+. (FYI: Acquisition costs, such as inspections and broker fees also apply toward the total cost of the new property.)
Rule 4: Must Not Receive “Boot”
A Taxpayer Must Not Receive “Boot” for the exchange to be completely tax-free. Any boot received is taxable to the extent of gain realized on the exchange. In other words, you can carry out a partial Like-Kind Exchange, in which the new property is of lesser value, but this will not be 100% tax free. The difference is called “Boot,” which is the amount you will have to pay capital gains taxes on. This option is completely okay, and often used when a seller wants to make some cash and is willing to pay some taxes to do so.
An example of this would be if your original property is sold for $2,000,000 and the property you wish to exchange under section 1031 is worth $1,500,000, you would need to pay the normal capital gains tax on the $500,000 “boot.”
Rule 5: Same Taxpayer
The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and title holder that buys the new property. (An exception to this rule occurs in the case of a single member limited liability company - which is considered a pass-through to the member, therefore, single member LLC may sell the original property, and that sole member may purchase the new property in their individual name)
For example, the single member of “Sally Jones LLC” is Sally Jones. The LLC can sell the property owned by the LLC, and because Sally Jones is the sole member of the LLC, she can purchase property in her name, and be in compliance with IRS 1031 code.
Rule 6: 45 Day Identification Window
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind. An exception to this is known as the 200% rule. In this situation, you can identify four or more properties if the value of those four combined does not exceed 200% of the value of the property sold.
Rule 7: 180 Day Purchase Window
It’s necessary that the replacement property be received and the exchange completed no later than 180 days after the sale of the exchanged property OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier.
IRS Form 8824 Like-Kind Exchanges: https://www.irs.gov/pub/irs-pdf/f8824.pdf
Instructions for IRS Form 8824: https://www.irs.gov/pub/irs-pdf/i8824.pdf
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