Deferring Taxes on Real Estate Transactions Through Like-Kind ExchangesJuly 10, 2012
John A. Lynch, CPA, MST
Kevin D. Fontana, CPA, MSA
Real estate is often the largest and most valuable asset held by a business. There comes a time in the life cycle of a business where either expansion or sale of a property is contemplated by the owner. There are several tax considerations and advantages that are perfectly legal (assuming the rules are followed) to preserve cash flow that would otherwise go to Uncle Sam upon the sale of appreciated real estate.
Fortunately, there is a way to defer the immediate tax and to also help reduce borrowing needs on the purchase of a replacement property. Congress has long recognized the tax issues faced by businesses attempting to relocate for either expansion or diversification, and has legislated (via the tax code) certain provisions that allow deferral of gains that ordinarily would be subject to immediate tax.
Assuming that a suitable replacement property can be identified, an exchange of properties can be arranged. If the properties are considered “like-kind”, the person generally does not have to pay current tax on the exchange.
The basic premise is this: the rules for like-kind exchanges apply to investment or commercial property (they cannot be used for residential homes). This refers to the nature, character or class of the property – not its grade or quality. For instance, a swap of an office building for an apartment building of the same value can qualify as a like-kind exchange. As a result, neither party has to report taxable income.
For example, a company that has outgrown its existing facilities will need to sell and purchase real estate which, without these rules, would be considered two separate transactions, the first of which (the sale) would be subject to tax (assuming the property has appreciated in value). This reduces the cash flow from the sale that the owner would be able to apply towards a down payment on the new property. The like-kind exchange rules, if followed properly, allow a deferral of the gain on the sale and the related tax to a future period assuming all of the sales proceeds are reinvested in the replacement property.
In a forward exchange, the property is sold and several possible replacement properties are identified, but the actual purchase of the replacement property often occurs later. In a reverse exchange, the replacement property is acquired first and the sale of the existing property occurs later. In either case, the proceeds from the sale must be restricted and must not be accessible by the seller. The IRS has approved the use of a qualified intermediary to facilitate the deal (i.e. hold the proceeds in a forward exchange and the replacement property in a reverse exchange), as long as the intermediary is not connected with one of the other parties.
An exchange can also involve multiple parties. For example, Company A wants to acquire a new property from Company B and sell its existing property to Company C. Company A can still receive like-kind exchange treatment, provided that the rules are met. In general, the replacement property must be identified within 45 days of the original transfer, and title to the replacement property must be taken within 180 days (or the tax return due date plus any extensions, if that is sooner). Assuming like-kind properties are involved, the entire transaction may be tax free if the deal is completed within these time frames. However, one item to consider is that if any money or property is received as part of the deal, that additional amount – called “boot” – is subject to income tax. This includes a reduction of the amount owed by the taxpayer.
Although other types of property (vehicles, equipment, etc.) may qualify under the rules, the majority of like-kind exchange transactions involve real estate.
One of the potential pitfalls of the like-kind exchange provisions is carryover basis, which results in limited future depreciation deductions. Also, the like-kind exchange provisions may apply even though the taxpayer didn’t contemplate them applying to their situation (the provisions are not elective – if the requirements are met, they automatically apply).
In general, the like-kind exchange provisions may not make sense for all situations. Consideration must be given to current and future tax rates, the time constraints to complete the transaction and the current market conditions.
Finally, because this is a complex area of the tax law, failure to comply with the rules could be disastrous, so professional assistance is a must.