The tax and accounting professionals at Berman Goldman & Ribakow (bgr CPAs) explain why a like-kind exchange may prove to be beneficial when used for business or investing purposes.
What is a “like-kind exchange”?
Prior to 1984, 1031 exchanges had to be exact — if, for example, you were selling a single-family home, you must in turn acquire another single-family home. However, times have changed, and the concept of property exchanges has grown broader making it easier to comply with IRS stipulations. In turn, an exact exchange is not necessary if the assets for exchange are similar in nature. The IRS deems that property which has appreciated in value can be sold with the proceeds invested in another property—all while deferring the taxes—if the deal is structured as a “like-kind” exchange rather than a sale. This will enable the total appreciation in your property to be applied, undiminished by the tax that would otherwise be payable, towards acquiring replacement property.
Conditions for a like-kind exchange
· Simple Exchange: There must be an exchange, rather than a sale and purchase, of properties.
· Business/ Investment: You must hold both the property traded and the property received for business or investment purposes. Property used primarily for personal use, like a primary residence, a second home or vacation home, will not qualify for like-kind exchange treatment. A taxpayer’s intent may determine whether the property meets the requirement for business or investment use.
· Similar Properties: The properties must be of like kind—for example, real estate can be traded for real estate. Similarly, improved real estate can be traded for unimproved real estate, and vice versa.
· Excluded Property: Properties cannot be considered excluded property, such as stocks, bonds, notes, securities, evidences of debt or partnership interests. In addition, the property traded and received must not be held primarily for sale, such as inventory.
Types of Exchanges
The most common types of exchanges are “simultaneous” exchanges, and “deferred” exchanges. A simultaneous exchange is one in which you trade your property for property that another party already owns. Thus, the transfers occur contemporaneously. A deferred exchange is one in which you transfer property in exchange for the other party’s promise to acquire and transfer property of like-kind to you.
Deferred exchanges must satisfy two timing rules. First, within 45 days of the transfer of your property, you must give written identification of the property you want to receive. Second, you must receive that property by the earlier of 180 days after you transfer your property, or the due date of your tax return (including extensions) for the year of your transfer.
A qualified intermediary should be used to handle a deferred exchange. This eliminates the purchaser’s participation in the completion of the deferred exchange. Due diligence and care should be used when selecting a qualified intermediary to ensure they are reputable and financially sound. Both the exchange agreement with the intermediary and any escrow or trust agreement must expressly limit your right to receive, pledge, borrow or otherwise obtain the benefits of the cash or cash equivalent received from the purchaser before the end of the exchange period. Also, neither the intermediary nor the escrow holder or trustee may be a “disqualified” person, such as your agent or someone who is “related” to you or your agent.
· The tax consequences to the other party do not affect your tax status.
· If the properties are not equal in value, one party can transfer cash or other non-like-kind property (“boot”) to equalize the exchange. Although the boot is taxable to the recipient, the transaction will usually still qualify for the favorable tax treatment.
· If you transfer a liability in the exchange, the liability is treated as cash and thus is taxable to you, unless you assume, or acquire the replacement property subject to, at least an equal amount of liabilities.
For additional information regarding like-kind exchanges as it relates to the deferment of taxes or to consult with a skilled tax professional on how you could benefit from these tools, please contact the experienced professionals at bgr CPAs today.