Are you planning on selling business or investment real estate? You may be able to dispose of appreciated real property without being taxed on the gain by exchanging it rather than selling it. You can defer tax on your gain through the “like-kind” exchange rules.
A like-kind exchange is any exchange of real property held for investment or for productive use in your trade or business (relinquished property) for like-kind investment real property or trade or business real property (replacement property). For these purposes, “like-kind” is very broadly defined and most real property is considered to be like-kind with other real property. However, neither the relinquished property nor the replacement property can be real property held primarily for sale. If you are unsure whether the property involved in your exchange is eligible for a tax-free like-kind exchange, please call and we can discuss the matter.
Assuming the exchange qualifies, here’s how the tax rules work:
If it’s a straight asset-for-asset exchange, you will not have to recognize any gain from the exchange. You will take the same “basis” (your cost for tax purposes) in the replacement property that you had in the relinquished property. Even if you do not have to recognize any gain on the exchange, you still have to report the exchange on Form 8824.
Frequently, however, the properties are not equal in value, so some cash or other (non-like-kind) property is tossed into the deal. This cash or other property is known as “boot.” If boot is received, you will have to recognize your gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you get in the like-kind replacement property you receive is equal to the basis you had in the relinquished property you gave up reduced by the amount of boot you received but increased by the amount of any gain recognized. If boot is paid, your basis in the new property is the amount of boot paid, plus the basis in the relinquished property.
Example. Ted exchanges land (investment property) with a basis of $100,000 for a building (investment property) valued at $120,000 plus $15,000 in cash. Ted’s realized gain on the exchange is $35,000: he received $135,000 in value for an asset with a basis of $100,000. However, since it’s a like-kind exchange, he only has to recognize $15,000 of his gain: the amount of cash (boot) he received. Ted’s basis in his new building (the replacement property) will be $100,000: his original basis in the relinquished property he gave up ($100,000) plus the $15,000 gain recognized, minus the $15,000 boot received.
Note that no matter how much boot is received, you will never recognize more than your actual (“realized”) gain on the exchange.
If the property you are exchanging is subject to debt from which you are being relieved, the amount of the debt is treated as boot. The theory is that if someone takes over your debt, it’s equivalent to his giving you cash. Of course, if the replacement property is also subject to debt, then you are only treated as receiving boot to the extent of your “net debt relief” (the amount by which the debt you become free of exceeds the debt you pick up). In other words, be very wary of arrangements where you end with less debt than you started with.
Like-kind exchanges are an excellent tax-deferred way to dispose of investment or trade or business assets. If you have additional questions or would like to discuss the topic further, please contact us. DMJ also has an extended write-up on this subject matter available on our web site.