By Dustin Cutlip
Many of you may be familiar with the term “like-kind” exchange, but are you familiar with how it can benefit you or your business? Or how the Tax Cuts & Jobs Act (TCJA) impact exchanges?
In general, Sec. 1031 of the Internal Revenue Code allows certain appreciated property transactions to be structured in a way that defers gain recognition to a future tax year. By doing so it allows taxpayers to keep 100% of capital, or equity, invested without losing a portion to foot the tax bill. This can be quite favorable compared to a sale which could trigger a tax liability at the time of sale.
However, not all property is eligible for deferral treatment under Section 1031. Property that is held for investment or used in business is eligible when exchanged for property of “like-kind.” The term “like-kind” may not be as rigid as you might think, and for those in the real estate industry the term actually provides a great deal of flexibility. For example, an apartment building doesn’t necessarily have to be exchanged for another apartment building, it can be exchanged for a warehouse or office building.
Years ago “like-kind” exchanges were structured by simply having two owners swap “like-kind” properties simultaneously, but in today’s world that is a very uncommon occurrence. It is far more common now to have non-simultaneous exchanges, while using the services of Qualified Intermediaries (QI). A QI is a third party facilitator who handles the paper work and compliance matters related to the exchange. With the help of a third party QI, non-simultaneous exchanges are generally structured in two ways: 1 – Deferred exchange – which is when you relinquish your current property and then identify a replacement property or 2 – Reverse exchange – which is when you purchase a replacement property and then relinquish your current property.
Time and Money
There is an old saying time is money, and that is certainly true with “like-kind” exchanges. A strict timetable is applied for both “deferred” and “reverse” exchanges that must be followed in order to comply with the rules under Sec. 1031. In general, both types of exchanges follow a 45 / 180 day rule. In a “deferred” exchange a replacement property(s) must be identified within 45 days of relinquishing the original property. Then the purchase must be completed within 180 days of relinquishing the original property. In a “reverse” exchange the relinquished property must be sold within 180 days of purchasing the replacement property. Thankfully a good QI will help you successfully navigate these deadlines to ensure compliance.
As potential replacement properties are identified in a “like-kind” exchange it is very important to analyze your coverage limits and determine how much you need to invest in a replacement property in order to ensure the exchange is completely tax deferred. It is common for taxpayers to overlook this step and end up with an exchange that is partially taxable when they were expecting a full deferral. As a general rule of thumb the purchase price of a replacement property must at least be equal to the sales price of the relinquished property while maintaining an equal or greater equity spread.
Let’s use some simple numbers to demonstrate. If you are selling a warehouse for $1,000,000 that has a $500,000 mortgage (equity of $500,000) you must find a replacement property with a purchase price of at least $1,000,000. In addition you must maintain at least $500,000 in equity, meaning no more than $500,000 of the purchase can be financed with debt (assuming a purchase price of $1M). If a replacement property is purchased at a price lower than what the relinquished property sold at, or at an equal price but financed with more debt, the exchange would still be valid but not fully tax deferred.
During the initial stages of the TCJA, there was some concern that “like-kind” exchanges would be completely eliminated from the tax code. As it turns out, “like-kind” exchanges are still part of the tax code, but personal property is no longer eligible for “like-kind” exchange treatment. This change became effective for 2018 going forward. As a result of this change taxpayers should be mindful that the exchange of business use autos, or other business use personal property, could now have an immediate tax consequence attached to the exchange.
While business and investment use real estate are still eligible for “like-kind” exchange treatment, any tangible personal property, such as furniture, which is sold with such real estate would have to be separately reported and the gain from the sale of the personal property would be realized in the year of exchange. Taxpayers should be mindful of this change as they negotiate the allocation of the sales price in future exchange transactions.
In theory, a “like-kind” exchange seems quite simple – relinquish property A, replace with “like-kind” property B, and defer tax to a future year. In actuality the process can be very complex and the rules must be followed carefully in order to achieve the desired outcome without any unforeseen consequences.
It is always best to consult your tax advisor prior to entering into a “like-kind” exchange, and that is where we come in! Please contact your Snyder Cohn advisor for more information!