The 1031 like-kind exchange is a powerful strategy to save on your taxes immediately. However, it can be complex and confusing to a non-accountant.
We put this guide together to make like-kind exchanges easy to understand. This guide will tell you everything there is to know about like-kind exchanges and how you can use them in your business.
Table of Contents
What is a like-kind exchange?
A like-kind exchange is a way to defer your capital gains taxes when selling a piece of business property.
In a like-kind exchange, you are essentially swapping your current property for a new one. This swap allows you to defer any capital gains you would have paid until you sell the new property. Theoretically, you can continue to swap your property forever and never have to pay any capital gains taxes.
What qualifies as a like-kind exchange?
A like-kind exchange only applies to business and investment property. Your personal home and vacation home do not qualify. However, a home that you rent out may be eligible.
A like-kind exchange does not mean you have to swap a building for a building. Instead, you can swap that building for land, an apartment complex, or a strip mall. You can even exchange one business for another. However, you cannot trade your property for artwork, collectibles, stocks, or bonds.
Advantages of a Like-Kind Exchange
Let’s say that ten years ago you purchased a building for your business office for $200K, and it is now worth $500K. The building is no longer suitable for your needs, and you want to sell it. If you sell the building, you would owe capital gains tax on $300K.
However, in a like-kind exchange, you can sell your old property and acquire new property without paying any taxes. For example, you would swap your property valued at $500K for a new property valued at $500K. This swap allows you to defer any capital gains taxes until you sell your replacement property.
Disadvantages of a Like-Kind Exchange
A like-kind exchange is not a get out of taxes-free card. If you choose to sell your replacement property, you will owe taxes on the basis of your original property.
For example, let’s say you originally purchased a property for $200K and it is now worth $500K. You performed a like-kind exchange and received a replacement property for $500K. A couple of years later, that property is worth $650K, and you want to sell it without replacing it.
In this case, your tax basis in the property you want to sell is still $200K. So, you will have to pay capital gains tax on $450K when you sell the property.
How to do a like-kind exchange
Step 1: Choose a Qualified Intermediary
You cannot perform a like-kind exchange without a qualified intermediary. A qualified intermediary facilitates the like-kind exchange by holding the funds from the sale until they can be transferred to the seller of the replacement property.
If you individually receive the proceeds from the sale, you will no longer receive the tax-deferred benefits of the like-kind exchange.
Step 2: Sell your property
Now that you’ve contracted with a qualified intermediary, you can safely complete the sale of your property. After the sale, the intermediary will receive the cash and hold it in escrow until you have closed on your replacement property.
Step 3: Identify Your Replacement Property
Within 45 days of the sale of your property, you must identify the replacement property to your qualified intermediary in writing. In addition, you must meet one of the following three rules for the replacement property to be valid.
Rule 1: Three-Property Rule
This rule allows you to identify three options as potential replacement properties regardless of their market value.
Rule 2: 200% Rule
This rule allows you to identify an unlimited number of replacement properties as long as their cumulative value does not exceed 200% of the value of the property sold.
Rule 3: 95% rule
This rule allows you to identify an unlimited number of replacement properties with a total value of more than 200% of the property sold as long as you acquire at least 95% of the value of the properties identified.
Step 4: Close on your property
You must close on the replacement within 180 days of the sale date of your original property. Note that the 180 days start immediately after you sell the property. NOT 180 days after you identified replacement property.
The qualified intermediary will transfer the funds held in escrow to the seller, and the titleholder will transfer the property to you.
What is a Reverse Like-Kind Exchange?
A reverse like-kind exchange is when you acquire your replacement property before you dispose of your current property. The same rules apply, including the requirement to dispose of your property within 180 days of acquiring the new property.
Also, it is important to remember that you cannot own both properties simultaneously. You must transfer your current property to a qualified intermediary before closing on the replacement property.
What happens if you have leftover cash?
After your qualified intermediary acquires the new property, you may have leftover cash. This cash will be paid to you at the end of the 180 days and will be taxed as a capital gain from selling the property.
What happens if you have a mortgage on the property?
Let’s say that the property you are exchanging had a mortgage of $200,000. Additionally, let’s say that the property you acquired only had a mortgage of $150,000. In this case, you will have to pay capital gains tax on the $50,000 reduction in mortgage liability.
Like-Kind Exchange and Estate Planning
The main advantage of a like-kind exchange is that you can immediately defer any taxes on the sale of your property. However, if you ever wish to cash out, you may get stuck holding a big tax bill.
But if you are looking to pass wealth down to your family members after your death, like-kind property is the best way to do that. This is because the basis of the property is immediately increased to the fair market value on the day of your death.
So, let’s say that you have a basis in your property of $200K, and the FMV of the property is $1M. If you were to sell the property today, you would have to pay capital gains tax on $800K. But, if your family inherits the property after your death, the basis and fair market value will both equal $1M. Therefore, your family can immediately sell the property without paying any taxes.
Beware of Depreciation Recapture
The IRS allows businesses to depreciate property over their useful life. Depreciation has the immediate effect of reducing your taxable income. However, when you sell depreciated property, you have to add the depreciation into your gain.
For example, you purchased a building for $200K and sold it for $400K. But, you also took $100K in depreciation. This means your tax basis in the building is only $100K, and you will have to pay capital gains tax on $300K.
Tax Implications and Key Takeaways
As a result of your like-kind exchange, you may still owe on your taxes. The following are some important considerations to keep in mind:
- Your taxes are not eliminated, only deferred
- Capital gains tax may occur for any leftover cash
- If you acquire a property with a smaller mortgage than the relinquished property, you will be taxed on the difference
- You will be taxed on the sale of your property if you are not able to close on a replacement property within 180 daysYou will be taxed at the basis of your original property when you sell your replacement property.
The 1031 like-kind exchange is an incredible way to defer taxes. It is also a great tool to consider in estate planning. However, the 1031 exchange can be complex, and it is not advisable to carry one out without expert advice.
At Windstone Financial, we help our clients minimize their tax liability and build wealth through innovative and proactive tax planning. If you need help lowering your taxes and planning for the future, click the button below to speak with a CPA today!