Have you been thinking of selling a property that is used for business or held as an investment, but do not want to pay the capital gains tax created from the sale?
One way to defer that tax bill on the gain is with a Section 1031 “like-kind” exchange. A Section 1031 “like-kind” exchange, hereafter referred to as a like-kind exchange, is where you exchange your property (the “disposed” property) with another property (the “acquired” property) of similar use, rather than just selling it. With real estate prices up in most markets creating significant taxable capital gain income, the like-kind exchange strategy may be an attractive one.
For these purposes, like-kind is broadly defined with most real property being considered as like-kind with other real property. However, neither the disposed property nor the acquired property can be real property ‘held primarily for sale’. In plainer terms, the property must be: 1). intended to be held for investment or 2). used in a trade or business.
Recent Tax Law Changes
Under the Tax Cuts and Jobs Act, like-kind exchanges are no longer allowed for the sales of “personal property” — such as equipment and certain personal property building components — that are completed after December 31, 2017. After 2017, like-kind exchanges can only occur with business or investment real property. If you’re unsure if the property involved in your exchange is eligible for like-kind treatment, please contact your Wegner CPA accountant to discuss the matter.
Tax Mechanics of a Like-Kind Exchange
Assuming the exchange qualifies after the new tax law changes, here is how the tax rules work. If it’s a straight asset-for-asset exchange (no cash or debt involved), you won’t have to recognize any gain from the exchange. You’ll take the same “basis” (your cost for tax purposes) in the acquired property that you had in the disposed property. Note: even if you don’t have to recognize any gain on the exchange, you must report the exchange on your tax return on Form 8824, “Like-Kind Exchanges.”
Frequently, however, the properties are not of equal value, so some cash or other property is added to the deal. This cash or other property is commonly referred to as “boot.” If boot is involved, you do have to recognize a gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you receive on the acquired property is not as straightforward as above. The basis you obtain in the like-kind acquired property is equal to the basis you had in the disposed property reduced by the amount of boot you received but increased by the amount of any gain recognized. Let’s work this out with an example below.
Example with Boot
Let’s say you exchange land used for business (disposed property) with a basis of $100,000 for a building to be used for business (acquired property) valued at $120,000 plus you receive $15,000 in cash.
“Acquired” Property Basis:
Building = $ 120,000
Cash = $ 15,000
Total = $ 135,000
“Disposed” Property Basis:
Land = $100,000
Your realized gain on the exchange is $35,000 (i.e., $135,000 less $100,000). However, since it’s a like-kind exchange, you only have to recognize a gain of $15,000 (i.e., equal to the cash/boot received).
Your basis in the new building, the acquired property, will be $100,000: $100,000 (your basis in the land/disposed property) plus $15,000 (recognized gain) minus $15,000 (boot received).
Note: if you received $40,000 in cash (boot), your recognized gain would become $35,000. No matter how much boot you receive, you would never recognize a gain larger than your actual “realized” gain on the exchange.
If the property you’re exchanging is subject to debt from which you’re being relieved, the amount of the debt transferred is treated as boot. The theory is that if someone takes over your debt, it’s equivalent to the person giving you cash. Of course, if the acquired property is also subject to debt, then you’re only treated as receiving boot to the extent of your “net debt relief” (the amount by which the debt you become free of exceeds the debt you pick up).
As you can see from the example above, like-kind exchanges can be a great tax-deferral strategy when you dispose of investment or business real property. But the transaction reporting including gain reporting vs deferral can also become very tricky, very fast. Please contact us to help you through the process and to discuss the strategy further. FYI: The best time to contact us is BEFORE the transaction occurs.