Like-kind exchanges provide a unique money-saving and investment tool for businesses and taxpayers. Section 1031 of the Internal Revenue Code, which governs like-kind exchanges, provides taxpayers the opportunity to defer the gain recognized from the sale of assets, provided certain requirements are met. By postponing paying taxes on the gain, the proceeds can be reinvested in similar property that can be used to grow a business.
What qualifies as a like-kind exchange
In general, a taxpayer must reinvest the proceeds from the sale of an asset into the purchase of qualifying, like-kind property to comply with Section 1031 and properly defer the gain from the sale. Real property, such as land, mineral interests and rental real estate, is typically considered like-kind to all other real property.
"Real property, such as land, mineral interests and rental real estate, is typically considered like-kind to all other real property."
The rules governing the exchange of tangible property are much more stringent. To qualify for a like-kind exchange of tangible personal property, the property must be almost identical. For instance, if you sold a drilling platform, you would not be able to defer the resulting gain by reinvesting the proceeds into a vehicle, as a drilling platform and a vehicle are not part of the same asset class.
There are a few additional guidelines that must be considered when executing a like-kind exchange. Section 1031 requires the taxpayer to identify the replacement property in writing within 45 days of selling the original property. The transaction must also be completed by the due date of the tax return, including extensions, or 180 days from the date of sale. Furthermore, all or part of the transaction can become taxable if cash or unlike property is received as part of the exchange.
How like-kind exchanges are structured
Although the name suggests an exchange of similar property between two parties, Section 1031 transactions can be structured as a sale of property to one party and a subsequent purchase of property from another party. As a best practice, a qualified intermediary should facilitate the actual exchange and handle the cash associated with the sale via an escrow account.
When all requirements of a like-kind exchange have been met and the transaction has been completed, the replacement property will use the relinquished property's basis as its own. The basis will be increased by:
- Non-like-kind property transferred
- Net cash paid
- Gain recognized as part of the transaction
"A taxpayer can potentially defer the gain from a like-kind exchange with consecutive, future like-kind exchanges."
For tax purposes, the taxpayer will depreciate the replacement property's basis using the normal methods and conventions. The deferred gain resulting from the like-kind exchange will not be recognized until the replacement property is sold in a taxable transaction. This means the taxpayer can potentially defer the gain from the Section 1031 transaction perpetually by exchanging the replacement property in consecutive, future like-kind exchanges.
Additional guidance for like-kind exchanges
Taking advantage of like-kind exchanges can be a useful tax strategy for most business. However, there is an additional incentive for businesses in the oil and gas or real estate sectors because of the liberal rules concerning exchanges of real property.
Despite the simple concept, the rules governing Section 1031 transactions can be complex. To fully make the rewards of this tax benefit worthwhile, taxpayers are advised to work closely with their financial advisor before attempting to structure such transactions.
The highly credentialed professionals in the LaPorte Tax Services Group are trained in understanding the complexities and unique compliance issues related to tax law and are able to guide our clients to full compliance in like-kind exchanges.