Many business owners are somewhat familiar with the concept of a Section 1031 “like-kind” exchange, but are not aware of the several options surrounding it. Proper planning can result in significant cash flow advantages from a like-kind exchange when reinvesting proceeds from the sale of a property in to the purchase of a new property.
Like-kind exchanges: A refresher
A like-kind exchange goes by many names – a Section 1031 exchange, a Starker exchange, a “tax-free” exchange (although “tax-free, for now” would be a better term), etc. Normally, when a taxpayer sells property at a gain, they will owe tax on that gain. However, with like-kind exchanges, if the owner uses the proceeds from that sale to reinvest in property that is similar in nature (i.e., equipment for equipment, or real property for real property), the gain from the sale, and the corresponding tax burden, can be deferred by reducing the basis of the new property. The original gain will therefore not be subject to tax until the new property is sold at some point in the future. The only catch is that both the old property and the new property must be held for investment, or for productive use in a trade or business – both of which have specific meanings for tax purposes.
Exchange requirements
All like-kind exchanges must use a qualified intermediary (QI) to assist with both the selling of the old property and the acquisition of the new property. The QI holds the sales proceeds from the old property until the new property is acquired in order to comply with tax laws and ensure that the sales proceeds are used specifically to acquire the new property. After selling the old property, the new property must be identified by the taxpayer to the QI within 45 days of the sale. If the new property is acquired before the old property is sold, then the QI must hold the new property until the like-kind exchange is complete (i.e., the old property is sold).
In either case, the taxpayer must sell the old property and acquire the new property within 180 days, or six months, of each other. After the exchange is complete, however, the taxpayer will not owe any tax related to the gain on the sale of the old property in the year of the exchange. The gain from the old property is offset against the basis of the new property, which results in the gain, and the related tax burden, being deferred until the new property is sold at some point in the future.
Know your options
There are several variations on the direct property-for-property exchange for which the tax benefits of a like-kind exchange are available. Two examples include Improvement/Build-to-Suit Exchanges and Partial Exchanges.
- Improvement/Build-to-Suit Exchanges
If you want to do a like-kind exchange, and make improvements to the new property with some of the proceeds from the sale of the old property, you could initiate an “improvement” or “build-to-suit” exchange. This allows you to add improvements to the new property and still defer the gain from the original sale. In this case, the title to the new property will sit with an exchange accommodation titleholder (EAT) until it is ready to be transferred to the taxpayer. Again, the improvements to the new property will have to be completed within 180 days, but this option allows for some flexibility on how the cash from the old property is reinvested.
- Partial Exchanges
Reinvesting some of the cash from a sale and taking the rest out at the end of the exchange is allowed; however, any cash taken out will be taxable in the year it is received. Conversely, if a taxpayer wants to add cash to the exchange in order to acquire or improve the new property, that is allowed as well – the cash given up will simply be added to the basis of the new property. Partial like-kind exchanges give business owners options and eliminate the “all or nothing” scenario when deciding how to best reinvest their cash.
Take another look
Although they require careful planning and documentation to meet Internal Revenue Service requirements, like-kind exchanges can result in significant cash flow advantages. Even property that is financed with a secured loan or mortgage could be eligible for a like-kind exchange. If you are planning to sell property and reinvest the cash in the near future, it is always worth a call to your tax advisor to see what options are available to help reduce your tax burden.
