Defer tax with a like-kind exchange

Section 1031 like-kind exchange

Do you want to sell commercial or investment real estate that has appreciated significantly? One way to defer a tax bill on the gain is with a Section 1031 “like-kind” exchange. Meaning you exchange the property rather than sell it. The like-kind exchange strategy may be attractive with real estate prices up in some markets (and higher resulting tax bills).

A like-kind exchange is an exchange of real property held for investment or productive use in a trade or business (relinquished property) for like-kind investment, trade, or business real property (replacement property).

For these purposes, “like-kind” has a broad definition, and most real property is considered like-kind with other real property. However, neither the relinquished property nor the replacement property can be real property held primarily for sale.

Important Section 1031 change

Under the Tax Cuts and Jobs Act, tax-deferred Section 1031 treatment is no longer allowed for personal property exchanged after December 31, 2017. Personal property includes equipment and specific personal property building components.

Contact our RRBB accountants and advisors to determine if the property involved in your exchange is eligible for like-kind treatment.

Assuming the exchange qualifies, here’s how the tax rules work. If it’s a straight asset-for-asset exchange, you won’t have to recognize any gain from the exchange. Instead, you’ll take the same “basis” (your cost for tax purposes) in the replacement property that you had in the relinquished property. Even if you don’t recognize any gain on the exchange, you still must report it on Form 8824, “Like-Kind Exchanges.”

Frequently, however, the properties aren’t equal in value. In that case, the deal will often also include cash or other property (“boot”).

With boot involved, you must recognize your gain, but only up to the amount of boot received in the exchange. In these situations, the basis you get in the like-kind replacement property you receive is equal to the basis you had in the relinquished property you gave up, reduced by the amount of boot you received but increased by the amount of any gain recognized.

Like-kind exchange example

Let’s say you exchange land (business property) with a basis of $100,000 for a building (business property) valued at $120,000 plus $15,000 in cash. Your realized gain on the exchange is $35,000. Meaning you received $135,000 in value for an asset with a basis of $100,000. However, since it’s a like-kind exchange, you only have to recognize $15,000 of your gain. (The amount of boot received.) Your basis in your new building (the replacement property) will be $100,000. Your original basis in the relinquished property you gave up ($100,000), plus the $15,000 gain recognized, minus the $15,000 boot received.

No matter the amount of boot received, more than the actual (“realized”) gain on the exchange won’t be recognized.

A property exchanged subject to debt relief results in the debt amount treated as boot. The theory is that if someone takes over your debt, it’s equivalent to the person giving you cash. But, if the replacement property is subject to debt, you only receive boot to the extent of your net debt relief. The amount by which the debt you become free of exceeds the debt you pick up.

Great tax-deferral vehicle

A like-kind exchange is an excellent tax-deferred method to dispose of investment, trade, or business real property. Contact our RRBB accountants and advisors if you have questions or would like to discuss the strategy further.

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