July 14, 2024

What Is a Like-Kind Exchange? Pros & Cons

What Is a Like-Kind Exchange?

A like-kind exchange is a tax-deferred transaction that permits the transfer of one asset and the acquisition of a comparable asset, without incurring a capital gains tax liability resulting from the sale of the initial asset.

Prior to the tax legislation passed in December 2017, this could have involved exchanging a business for another or swapping a tangible property like artwork or heavy equipment for another. However, since 2017, the like-kind exchange only pertains to exchanging real estate investment property or a business for another property.

How does it work?

If an investor sells a commercial or investment property and earns a profit, they are obligated to pay a capital gains tax on that gain. The capital gain’s Tax rate depends on whether the property was held for a short-term or long-term period. Short-term capital gains, generated by selling the property within a year of its purchase, are taxed at a rate ranging from 10% to 37%. Meanwhile, long-term capital gains, resulting from selling the property more than a year after its initial purchase date, are taxed at a rate ranging from 10% to 20%.

Nonetheless, Section 1031 of the Internal Revenue Code (IRC) offers an exemption to the investor, allowing them to forego paying taxes on a gain if they reinvest the proceeds from selling or disposing of the property into another property of equivalent or greater value as part of a qualifying like-kind exchange. All real estate, except for the investor’s primary residence, is deemed like-kind to any other real estate, and real estate properties held for productive use in trade or business or for investment generally qualify for a like-kind exchange.

If a taxpayer sells an investment property and purchases another one within a specified time frame, they will not be required to pay taxes on the initial sale. However, they will have to pay taxes when they dispose of or sell the second property unless they carry out another like-kind exchange, in which case the tax payment will be deferred once again.

When engaging in a like-kind exchange, there are several crucial factors to bear in mind to avoid generating a tax liability on the sale of the initial asset.

  1. Firstly, the asset being sold cannot be a personal residence, it must be an investment property.
  2. Secondly, the asset being acquired using the proceeds from the sale must be comparable to the sold asset. Moreover, the purchase of the other asset must be made within 180 days of the sale of the initial asset, and you must identify the asset you are purchasing within 45 days of the sale as part of the like-kind exchange.
  3. Lastly, there are restrictions on the amount of capital gain that is tax-deferred, and it’s vital to verify the most recent tax rules before embarking on a like-kind exchange.

Special Considerations

Besides the tax deferral advantages, a like-kind exchange also enables the seller to postpone their depreciation recapture. This pertains to the gain obtained from the sale of depreciable capital property that needs to be reported as income for income tax purposes. Moreover, taxpayers can avoid state taxes on like-kind exchanges.

For instance, in certain states, either the buyer or the seller must pay state income taxes upon the sale of a property, also called state mandatory withholding. However, when a property is transferred in a like-kind exchange, it can receive an exemption from such taxes. To avail this exemption, the taxpayer must sign a state-provided exemption form or certificate. The seller might need to submit the exemption form 20 days before the closing in some states, while other states may allow submission at closing.

Advantages and Disadvantages of a Like-Kind Exchange

The most prominent advantage of a like-kind exchange is its favorable tax treatment. In a like-kind exchange, a similar asset can replace an existing one without resulting in a taxable event. The replacement asset doesn’t have to be identical to the one being replaced; it just needs to belong to the same asset class.

There is no limit set by the IRS on how frequently an individual can engage in a 1031 exchange. Hence, investors can keep seeking more profitable opportunities. Furthermore, the funds that would have been allocated towards paying capital gains taxes become available for reinvestment.

While a like-kind exchange presents tax advantages, they are not permanent. Taxes are deferred, but not exempted. The deferred capital gains taxes will eventually become due. Moreover, if the exchange fails to occur within the designated period or in accordance with the IRS regulations, the transaction will become taxable. Similar to capital gains taxes, losses are also deferred in a like-kind exchange. If the exchange involves losses, they must be carried forward.

PROS:

  • Deferral of capital gains tax
  • Increased funds available for reinvestment
  • Unrestricted number of exchanges

CONS:

  • Rigorous IRS guidelines
  • Postponed losses
  • Obligation to pay taxes still exists

Example of a Like-Kind Exchange

A like-kind exchange can benefit a business owner who wishes to sell their business and invest in another or a real estate investor looking to sell a rental property and purchase a similar one. To document the terms of the transaction, an 8824 Form must be submitted to the IRS. If boot, such as cash, liabilities, or other property that is not like-kind, is involved in the exchange, any recognized gain must be reported on Form 8949, Schedule D (Form 1040), or Form 4797, depending on the situation. If depreciation must be recaptured, any recognized gain may need to be reported as ordinary income.

The Bottom Line

In summary, a like-kind exchange provides advantageous tax benefits for eligible individuals. The deferral of capital gains taxes can be continued without any restrictions on the number of exchanges. However, the IRS imposes specific regulations on which assets can be exchanged and when the exchange can occur. It is important to note that losses in a like-kind exchange are deferred, and taxes cannot be avoided.

 

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