Property exchange can defer, not avoid, tax

 People erroneously refer to like-kind exchange transactions as “tax-free.” Typically, these are merely tax deferral strategies, as opposed to tax avoidance ones.

If you own business or investment property, you may be able to exchange it for “like kind” property without incurring a tax bill during the year of the swap. The tax on the gain is postponed until you ultimately dispose of the replacement property in a taxable transaction. There is no limit on the number of times you can do a 1031 exchange, and you can roll over the gain from one business or investment property to another and defer the tax as long as the exchange qualifies for the like kind treatment. For example, assume you purchased real estate for $40,000 several years ago and the property is now worth $70,000. When you sell the property in a qualified like kind exchange, the $30,000 gain is deferred and will reduce the basis of your replacement property. If you later sell the replacement property for $70,000, the gain would be taxed at that time.

If property received in a like kind exchange is held until death, the unrecognized gain escapes tax forever. This is because the heir generally receives a step up in basis to the fair market value of the property at the date of death.

In order to accomplish a like kind exchange, you must pay close attention and adhere to the IRS rules. We definitely recommend consulting with a tax professional to ensure the exchange is valid. Any property received that is not considered to be like kind (such as cash or a reduction in liabilities) as a part of the transaction will result in tax.

In a perfect world you would find someone with the exact property that you want and simply “swap” one property for the other. As a practical matter such an exchange is often difficult to achieve. In order to circumvent this problem, the tax law allows for an arrangement known as a “delayed exchange.” This allows an investor to sell his property and buy the “replacement property” at a later time as long as certain timing requirements are met. Property to be received in the exchange must be identified within 45 days of the initial property transfer and the exchange must be completed no more than 180 days after the initial property transfer (but not later than the due date of the taxpayer’s return). It is important to understand that receiving cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make all gain immediately taxable. There is also a safe harbor method of making a reverse exchange whereby you purchase the replacement property prior to selling your property.

Sellers wishing to enter into a delayed exchange should use a qualified intermediary to handle the exchange. It is important that the qualified intermediary have no pre-existing relationship with the seller. For example, the seller’s attorney, CPA, real estate agent or an employee would not qualify as an intermediary.

Real estate owners should seriously consider structuring transactions so that they qualify under the like-kind exchange provisions of the tax law. Although the tax-planning opportunities in this area are significant the rules are complicated and the required form of the transaction must be followed in order to achieve the desired tax savings. Be sure to consult with an expert in the area of tax deferred exchanges so that you can be certain the exchange transaction is structured properly in order for you to reap the full benefits of this tax-saving strategy.