The name of the game is to defer, defer, defer, and hopefully never pay the tax on your appreciated property. The vehicle often used to achieve this is the “like-kind exchange”. You might be able to dispose of appreciated property without being taxed on the gain by exchanging it rather than selling it. You can defer tax on your gain through the like- kind exchange rules.
A like- kind exchange is any exchange (1) of property held for investment or for productive use in your trade or business for (2) like- kind investment property or trade or business property. For these purposes, “like- kind” is very broadly defined. As long as the exchange is real estate (land and/or buildings) for real estate, or personality (non-real estate) for personality, it should qualify. However, exchanges of some types of property (for example, inventory or shares of stock), do not qualify. If you are unsure whether the property involved in your exchange is eligible for a tax-free like- kind exchange, seek expert advice.
Assuming the exchange qualifies, here’s how the tax rules work:
If it’s a straight asset-for-asset exchange, you will not have to recognize any gain from the exchange. You will take the same “basis” (your cost for tax purposes) in your new property that you had in the old property. Even if you do not have to recognize any gain on the exchange, you still have to report the exchange on Form 8824.
Frequently, however, the properties are not equal in value, so some cash or other (non- like- kind) property is tossed into the deal. This cash or other property is known as “boot.” If boot is involved, you will have to recognize your gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you get in the like- kind property you receive is equal to the basis you had in the property you gave up reduced by the amount of boot you received but increased by the amount of gain recognized.
Example. Ted exchanges land (investment property) with a basis of $100,000 for a building (investment property) valued at $120,000 plus $15,000 in cash. Ted’s gain on the exchange is $35,000: he received $135,000 in value for an asset with a basis of $100,000. However, since it’s a like- kind exchange, he only has to recognize $15,000 of his gain: the amount of cash (boot) he received. Ted’s basis in his new building will be $100,000: his original basis in the land he gave up ($100,000) plus the $15,000 gain recognized, minus the $15,000 boot received.
Note that no matter how much boot is received, you will never recognize more than your actual (“realized”) gain on the exchange.
If the property you are exchanging is subject to debt from which you are being relieved, the amount of the debt is treated as boot. The theory is that if someone takes over your debt, it is equivalent to his giving you cash. Of course, if the property you are receiving is also subject to debt, then you are only treated as receiving 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).
Like-kind exchanges are an excellent tax-deferred way to dispose of investment or trade or business assets. If you are able to continue to do this until your death, your beneficiaries will inherit the property at the fair market value at the time of your passing, and thus neither you nor them would ever pay the tax on the capital gain.
Deferred Like-kind Exchange
A “deferred” like-kind exchange is a type in which there is to be a delay in your receipt of the like-kind property. If the transactions involved are carefully timed to meet the like-kind exchange requirements, you should be able to defer the tax on all or part of your gain on the exchanged property. In certain cases, you can even accomplish a “reverse” deferred exchange, if, for example, you are interested in acquiring a particular property, but have not yet identified the property that you will be exchanging.
A deferred exchange may be necessary when you find a “customer” who wants your property but who has not yet acquired property to turn over to you in exchange or when you find a property that you want, but have not yet found property the
other person will be willing to accept in exchange. Or perhaps you have not yet determined your needs for replacement property and seek a delay in determining what property to accept in exchange.
Under the like-kind exchange rules, you can structure a deferred (non-simultaneous) exchange. You transfer your property to the other party but defer your receipt of replacement property. To qualify, the following time limits must be met:
(1) The property you are to receive must be “identified” no later than the day that is 45 days after your property is transferred. Identification must be made in writing and clearly describe in appropriate detail the property to be transferred.
(2) The actual transfer must occur no later than the earlier of:
(a) the day 180 days after your property is transferred, or
(b) the due date (including extensions) of your tax return for the year in which you gave up your property in the exchange.
It pays to be particularly careful with this second requirement. If you transfer your property in the exchange late in the year, you should not automatically assume that you have 180 days to receive the replacement property. Say you transfer your property on December 10th. If you don’t get an extension for filing your tax return, you will have to receive the replacement property in exchange by April 15th, which is earlier than the day which is 180 days after December 10th. Of course, in this case, a filing extension will give you additional time. Note, however, that no extensions can be obtained on the 45-or 180-day periods themselves.
Alternative arrangements. If the time limits outlined above are too restrictive in your case, we may be able to work out alternative arrangements which effectively give the exchanging party more time to come up with the replacement property. These arrangements can involve:
(a) leasing your property to the other party for a period of time, rather than transferring it outright,
(b) granting an option to buy your property to the other party which could be exercised when the replacement property becomes available, or
(c) transferring your property to an independent trust or escrow arrangement to be held until the exchange can be made.
A final possibility, mentioned earlier in reference to a reverse exchange, is a special transaction that IRS recognizes, called a qualified exchange accommodation arrangement. If you follow to the letter the rules IRS has set out, you can arrange to have the property you want to acquire transferred to an accommodation party until the property you will relinquish has been identified. The transaction turns the timing rule mentioned above on its head by requiring you to identify the property you intend to exchange, rather than the property you plan to receive in the exchange, within 45 days of the date that the replacement property is transferred to the accommodation party. As noted, this special transaction must be accomplished exactly in the way IRS requires in order for you to qualify for the favorable tax treatment.
Vacation Home Like-Kind Exchange
It is possible to do a like-kind exchange of your vacation home for another investment property in a tax-free like-kind exchange during the next three years. As you know, a tax-free like- kind exchange is any exchange (1) of property held for investment or for productive use in your trade or business (the relinquished property) for (2) like- kind investment property or trade or business property (the replacement property). In the case of vacation homes, it is sometimes difficult to establish that the relinquished property (or the replacement property) is held for investment or for use in a trade of business because the owner (or the owner’s family) occasionally uses the vacation home for personal purposes.
However, under a safe harbor, IRS won’t challenge whether a dwelling unit (a house, apartment, condominium, etc.) qualifies as property held for productive use in a trade or business or for investment even if the taxpayer occasionally uses the dwelling unit for personal purposes. Under the safe harbor, both the
relinquished property and the replacement property have to meet satisfy certain qualifying ownership and use standards. If the requirements of the safe harbor are satisfied, the exchange still has to satisfy all other requirements for a tax-free like-kind exchange.
To satisfy the safe harbor, a property owner has to hold both the relinquished property (immediately before the exchange) and the replacement property (immediately after the exchange) for at least twenty four months. In each of the two twelve month periods (immediately before the exchange and immediately after the exchange), the owner has to rent the dwelling unit to another person at fair market value for at least fourteen days, and the owner cannot use the dwelling unit for more than the greater of fourteen days or ten percent of the total number of days the property was used. For this purpose, the fair rental of a dwelling unit is based on all of the facts and circumstances that exist when the owner enters into the rental agreement. Personal use of a dwelling unit under the qualifying use standards generally occurs on any day on which an owner or certain family members are considered to have used the dwelling unit for personal purposes under the same rules that limit tax deductions for vacation homes.
If it is not possible to satisfy the requirements of the safe harbor, we can analyze the facts relating to your property to determine what evidence exists to support a conclusion that the property was held for investment purposes.
As you can see, the application of these rules can be quite complex. It is critical that you receive expert assistance in determining whether an exchange of your dwelling unit might be eligible for the safe harbor or whether any changes to your personal use of the dwelling unit might be necessary to satisfy the safe harbor’s qualifying use standards.
Selecting a Qualified Intermediary
The selection of a qualified intermediary (QI) for the like-kind exchange is critical in the exchange transaction process. The QI is responsible for acquiring the replacement property that you will identify during the exchange period as well as making sure that the numerous tax and legal requirements (including the strict deadlines for identifying and acquiring the replacement property) for a deferred like-kind exchange are satisfied. The selection of an appropriate QI should be conducted with due diligence and will be one of the most important decisions you will make in structuring a successful like-kind exchange.
One of the initial considerations is whether an intermediary is a “disqualified person” or a person not qualified to serve as a QI under IRS regulations. Under those rules, a disqualified person or entity cannot serve as QI if he or she is the taxpayer’s agent, a person or entity related to the taxpayer, and a person or entity related to the taxpayer’s agent. Also, a disqualified person also includes any person who has acted as the taxpayer’s employee, attorney, accountant, investment banker, broker, or real estate agent or broker, at any point during the two-year period ending on the date of the transfer of the relinquished properties. But, in determining whether a person or entity is an agent, activities that are routine financial, title insurance, escrow, or trust services for the taxpayer by a financial institution, title insurance company, or escrow company are disregarded. Also, the performance of services in connection with exchanges intended to qualify as tax-free like-kind exchange rules aren’t taken into account for purposes of determining whether a person is an agent.
Since the QI will be holding the exchange funds, it’s important to look into whether the QI has implemented sufficient policies and procedures to safeguard the exchange funds. You will also want to learn about a potential QI’s investment guidelines for the exchange funds.
It’s also important to investigate whether a potential QI maintains sufficient fidelity bond coverage to protect against any theft or embezzlement of the exchange funds. In addition, you should verify that the QI has sufficient errors and omissions (E&O) insurance coverage to protect against human errors and omissions that could potentially occur during the exchange.
Because a like-kind exchange is a highly technical transaction, it’s also important that any potential QI have sufficient technical expertise and experience to help you structure the exchange properly as well as solve any problems that arise during the exchange period. This technical expertise and experience is particularly important if the QI insists on using its own documents for the exchange.
Although you should not select a QI solely based on the amount of the fee, you should make sure that the fees charged by any QI are reasonable for your location and the services rendered.
Be sure to seek expert help in carrying out your due diligence with respect to the selection of a qualified intermediary.
Feel free to contact us at 714.672.0022 with any questions or to schedule a complimentary strategy session for expert advice. Here at LSL, our main priority is to help you succeed.
Submitted by Susan F. Matz, CPA
Susan oversees the tax processes at the firm as well as serving individuals and business owners with their accounting and tax strategies. Her achievements were honored by Cal Poly’s Accounting Department as an Outstanding Alumnus in 1998. She has also been twice named a Paul Harris Fellow for her contributions to Rotary. But accolades aside, she derives the greatest pleasure from helping clients gain peace of mind.
You can reach Susan at 714-672-0022.
Read Susan’s full bio.