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Deferring Real Estate Tax Gains Can Be An Effective Tax Strategy

If you're considering selling commercial property or trading up on a second home, you should consider a like-kind exchange.

A like-kind exchange under United States tax law, also known as a 1031 exchange, is a transaction or series of transactions that allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the sale of the first asset. In other words, no gain or loss is recognized.

In a like-kind exchange, the basis of the property received is the basis of the property transferred decreased by any cash received and any loss recognized on the exchange and increased by any cash or other consideration paid and any gain recognized on the exchange.

For a transaction to qualify for non-recognition treatment under the like-kind exchange rules, the following requirements must be met:

  • Exchange requirement: A transaction is an exchange where there is a reciprocal transfer of property between two or more taxpayers. The use of some boot (money or other non-like-kind property) does not destroy the exchange requirement. Receipt of boot will trigger partial recognition of gain.
  • Like-kind property: Property that the taxpayer exchanges must be of like kind to the property that the taxpayer receives. "Like kind" refers to the nature or character of the property, and not to its grade or quality. Real properties (land) generally are of like kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
  • Business or investment property: Both the property given and the property received must be held for productive use in a trade or business. For the purposes of the like-kind exchange rules, whether a property is held for investment or for use in a trade or business is determined by the taxpayer's intent at the time of the exchange. Incidental or occasional personal use of otherwise qualifying property does not disqualify the property from like-kind treatment.
  • Excluded property:Neither the exchange property nor the replacement property can be stock, bonds, notes, inventory or other assets held primarily for sale, debt securities, partnership interests, beneficial interests in a trust, or goodwill and going concern value.
    • Related party rule: In general, an exchange of like-kind property can qualify for non-recognition treatment even when the exchange is between related parties. However, an otherwise properly executed like-kind exchange may fail to qualify for non-recognition treatment if either of the properties exchanged is subsequently disposed of within two years of the exchange.

In general, a deferred exchange of property will qualify for non-recognition treatment as a like-kind exchange if the following additional requirements are met:

  • The property to be received by the taxpayer must be identified on or before the 45th day after the day the taxpayer transferred his property; and
  • The property must actually be received by the taxpayer by the earlier of:
    • the 180th day after the taxpayer transferred his property; or
    • the due date (including extensions) for the taxpayer's return for the year in which the taxpayer transferred the original property.

(Written by Deborah Lawrence, CPA & Principle at Bell & Company, PA.)