Also known as a 1031 exchange, a like-kind exchange is an IRS-eligible transaction that allows the owner of investment property to defer capital gains resulting from the hold and sale of the property. A like-kind exchange does not completely dismiss the owner’s requirement to pay the capital gains taxes associated with the appreciation in property value upon disposal; it only defers it.
Thus, a like-kind exchange is an investment technique that provides owners with the possibility to build wealth on an individual basis while spurring reinvestment into the broader real estate market. Prior to the revision to the United States’ tax code in 2017, individuals or entities could exchange businesses or tangible assets associated with the business’s operations such as machinery or other equipment. But now, like-kind exchanges can only include business or real estate investment properties.
Digging Deep Into Like-Kind Exchanges
When an investment property that generates passive income via rental revenue is sold, capital gains tax is due on the appreciated value of the property. The investor may also be subject to depreciation recapture tax if he or she lowered his or her annual tax liability due on taxable income from deductions taken from depreciation. The investor is taxed at either a short-term or long-term capital gains tax rate depending on the length of the hold period. The tax rate on short-term capital gains applies to profits realized on an asset held for a year or less and is generally equal to the individual’s or entity’s ordinary income tax rate. Long-term capital gains taxes are usually lower and depend on taxable income and filing status.
A 1031 exchange allows the investor to defer this tax liability indefinitely as long as the exchange is conducted each time the investor disposes of an investment property. Individuals are not allowed to defer capital gains tax on personal residences. That said, the scope of properties that can be disposed of and acquired in a like-kind exchange is very broad. The IRS states that like-kind property is property of the same character or class and that most real estate will be like-kind to other real estate, meaning that a condominium generating rental revenue is like-kind to vacant land, and a multifamily asset is like-kind to a ranch.
While the scope of what qualifies assets as like-kind is very broad, the IRS lays out stringent requirements and timelines for an exchange to qualify as a 1031 exchange. First, investors have 45 days from the date of the sale of the relinquished property to identify potential replacement properties. Second, the replacement property or properties must be acquired no later than 180 days following the sale of the relinquished property or the due date of the income tax return (including extensions) for the tax year in which the property is sold, whichever occurs first. Investors must also adhere to one of three rules with regard to the fair market value of the property:
- Three Property Identification Rule: This limits the number of properties an investor can identify as potential replacements in the 45-day window to three.
- 200% Identification Rule: If an investor wishes to formally identify more than three replacement properties, he or she can forgo the three-property identification rule and instead identify more than three replacements as long as the aggregate fair market value of the properties does not exceed 200 percent of the relinquished property or properties disposed of.
- 95% Identification Rule: Under this rule, there is no limit to the number of replacement properties identified or value of such properties as long as the property or properties acquired exceed 95 percent of the sale price of the relinquished property. If it does not, the 1031 exchange will be disqualified.
In addition to the stated timelines and rules regarding the fair market values of replacement properties, an investor must hire a Qualified Intermediary to conduct the transaction. In short, a Qualified Intermediary functions as an independent third party to ensure that the investor did not obtain access to the proceeds from the sale of the relinquished property during the exchange. Investors must also report the exchange to the IRS on a Form 8824, which includes:
- Descriptions of the properties exchanged
- Dates that properties were identified and transferred
- Relationship (if any) between parties in exchange
- Value of the like-kind property
- Gain or loss on the sale of the relinquished property
- Cash received or paid; liabilities relieved or assumed
- Adjusted basis of like-kind property disposed of, realized gain
Types Of Like-Kind Exchanges
A Forward Exchange is the most common type of 1031 exchange. In a Forward Exchange, an investor disposes of a relinquished property and acquires a replacement within the 180-day window.
A Reverse Exchange occurs when an investor does not dispose of a relinquished property prior to acquiring a replacement property. In a Reverse Exchange, the investor can commence the 1031 exchange at the time he or she is able to dispose of the relinquished property. An investor might unexpectedly identify an investment opportunity that he or she must act on before having time to consider selling or listing the relinquished property. The opportunity for a sale or disposition of the relinquished property may unexpectedly collapse, but a reverse exchange allows the investor to still acquire the replacement property prior to the disposal of the relinquished property. To avoid unwanted hassle, an investor may prefer to buy first to eliminate the pressure of having to identify your like-kind replacement property within the 45 calendar day identification deadline in a regular Forward 1031 Exchange.
A Build-to-Suit (Improvement) Exchange occurs when an investor acquires a replacement property and also wishes to apply a portion of proceeds from the exchange to improve or renovate the replacement property. In an Improvement Exchange, proceeds used to renovate the replacement property will qualify for tax deferral, whether it be a Class B apartment building or vacant land.
The Bottom Line
Like-kind exchanges are investment techniques that allow investors to defer capital gains taxes and thus the potential to grow wealth more rapidly. For nearly 100 years, the method has been in place to accelerate economic growth by providing real estate investors tax relief when disposing of investment properties and reinvesting in new assets. While the types of properties that qualify as like-kind are vast, the rules and timelines governing like-kind exchanges are very stringent. For this reason, investors should be abundantly aware of what needs to be done to qualify for a 1031 exchange, as failure to comply with one of any of the rules laid out by the IRS can result in a hefty tax bill due on the realized gain on an investment property.