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Like-kind exchanges and how they work
Follow four rules to make sure that taxable gains are deferred in like-kind exchanges.
By: Russell Schneidewind / December 04, 2017
Editor's note: This article was cowritten by Robert Reynolds, JD.
Additional editor's note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article was not affected by the 2017 TCJA.
Imagine that a taxpayer would like to dispose of some business or investment assets. Maybe it's an old piece of construction equipment that has some useful life, a rental property, or a vehicle. Sure, she could sell the property and net some cash, but she'll recognize all the gain from that transaction immediately and owe taxes on it for that year.
Many people in this position elect to "trade up" their unwanted business or investment property for something more useful. This transaction is called a like-kind exchange, sometimes known as a 1031 exchange. This exchange allows people (directly or through an intermediary) to exchange goods of the same type. In doing so, they can defer, but not exclude, the taxable gain from disposing of the property until they sell the property they received in the exchange. At that point, they'll owe taxes on the gain from both pieces of property.
This deferred gain is the main reason a person would want to use a like-kind exchange. However, when making this exchange, that person's basis in the first property becomes his or her basis in the second property.
Four rules to closely follow
To defer the gain on a 1031 exchange, the people involved must follow certain rules to the letter. If not, the IRS may entirely disregard the benefits they claim from the like-kind exchange. Failed 1031 exchanges result in a larger-than-expected tax bill because the IRS requires the individuals to recognize the gain and pay taxes on it (plus penalties and interest) in the year of the exchange.
Here are the four major rules that taxpayers and their advisors should know when it comes to like-kind exchanges:
1. The properties must qualify.
The property being exchanged must qualify for like-kind treatment. Here are some rules:
Qualifying property includes only business and investment properties.
Physical items, such as buildings, land, desks, trucks, and airplanes, can qualify.
Intangible property, such as patents and copyrights, can also qualify.
Certain categories of stocks, bonds, class interests in lawsuits, and business interests don't qualify.
2. The properties exchanged must be "like-kind."
This doesn't mean that the properties are in the same condition or are of the same quality. The IRS requires only that both pieces of property are in the same general asset class or product class. For example, individuals can exchange domestic real estate for other domestic real estate. Or, they can exchange a building for vacant land.
A qualifying like-kind exchange can include some additional not similar property or cash (often called "boot"). However, the recipient will owe tax on any boot he or she receives in the trade (cash, other property that is not like-kind, reduction in debt, etc.), in the year the exchange occurs. That's because boot typically isn't in the same asset or product class as the like-kind exchange property, and, therefore, is immediately taxable.
3. The parties must actually exchange items.
This is the biggest catch of the like-kind exchange. A sale of property and a subsequent reinvestment of that cash into a new piece of property, even if both pieces of property are of the same asset or product class, is not a like-kind exchange. Instead, this transaction is considered a sale and a separate purchase of a new property.
Example: Andrew is a commercial landlord. Andrew has an underperforming condo in his portfolio that he wants to unload so he can purchase a newer condo in the hot part of town. He sells the property to Kelsey, another landlord in town, and reinvests that property on the same day in a brand-new condo.
This is not a like-kind exchange, because Andrew didn't actually exchange his property, even though both properties are like-kind properties. Instead, Andrew sold his property and then reinvested the profits. He must report any gain from the sale on his return for that year and can't defer the gain.
Instead, say Andrew and Kelsey agree to exchange a condo that Andrew owns for a condo that Kelsey owns. This transaction is a like-kind exchange because Andrew and Kelsey are exchanging like-kind properties.
4. A Starker (deferred) exchange allows for an extended period to make the exchange.
In the Supreme Court case, Starker v. United States, the Court held that a promise to acquire like-kind property is just as good as exchanging the like-kind property itself.
A Starker exchange is a technical and specific way to achieve a deferred gain like-kind exchange. From the outside, Starker exchanges look like a sale-and-reinvest transaction, because in a Starker exchange one party is selling a piece of like-kind property and reinvesting the gain from that sale into a new piece of like-kind property. However, a Starker exchange is different because of the presence of a qualified intermediary.
In these exchanges, the seller gives up his or her right to the proceeds of the sale in exchange for a promise from the qualified intermediary (sometimes called an "accommodator") to purchase the new qualifying like-kind property with the proceeds from the sale. The new property must be identified within 45 days of the sale, and the exchange property must be acquired within 180 days of the sale of the first property, or the due date of the tax return, whichever is earlier. Without that promise from a qualified intermediary, the Starker exchange is merely a sale-and-reinvest transaction, with gain taxed immediately.
If the Starker exchange goes as planned, and the seller reinvests the proceeds in a new property through a qualified intermediary, then the seller has completed a like-kind exchange (with a deferred gain).
Example: Jim is a landlord who owns apartments free and clear of mortgages. He wants to rent out condos instead of apartments. He knows that another landlord, Dave, will put some of his condos up for sale shortly, but Dave is not interested in exchanging them for Jim's apartment complex.
So, Jim contracts with a qualified intermediary, Steve, a local attorney. Steve takes ownership of the apartments and completes their sale to Melissa on the same day that Dave's condos are listed for sale. Steve then makes an offer to Dave to purchase them and closes on the purchase 90 days after the sale of Jim's apartments.
Jim has successfully made a like-kind exchange of his apartments for Dave's condos. There may be some taxable gain if the sale price of Jim's apartments was higher than the purchase price of Dave's condos, but that amount is far less than the full sale price Jim would have incurred using the sell-and-reinvest strategy.
How to report the like-kind exchange
The like-kind exchange is reported on Form 8824, and each exchange requires a separate Form 8824. Any taxable boot or non-like-kind property received in the exchange must also be reported on Form 8949, Schedule D, and Form 4797, depending on the kind of property.
The like-kind exchange offers tax benefits for savvy investors, but taxpayers and their advisors must be careful to follow the rules exactly, or the IRS may not recognize the exchange as such, resulting in a potential unexpected tax bill and the accompanying interest and penalties.
Russell Schneidewind
Russell Schneidewind is a lead tax research analyst at The Tax Institute. Russell leads a research team focused on international taxpayer issues, such as foreign inbound and outbound business transactions, foreign investment rules, foreign real estate transactions, and foreign employment.
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