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People who sell real estate at a gain often want to use the proceeds to purchase additional real estate. However, people have to pay tax on the gain before they can use the proceeds to buy more real estate. Often, they are surprised that they have to pay tax on the gain when they’re rolling the proceeds into more real estate.
Taxpayers in this situation can avoid paying tax immediately on the sale by entering into a like-kind exchange. In a like-kind exchange, taxpayers exchange their property with another taxpayer’s property without cash exchanging hands. If taxpayers can’t find another party to exchange properties with, multi-party exchanges (described in my next blog) can be structured.
Like-kind exchanges can include business for business, business for investment, investment for business, or investment for investment property. Inventory, partnership interests, and stocks and bonds do not qualify for like-kind exchange treatment. The term like-kind refers to the nature and character of the property and not to its grade or quality. Real estate can be exchanged only for other real estate, and personal property can only be exchanged for other personal property.
A major benefit of like-kind exchanges is that the taxpayer can acquire new property on a pre-tax basis.
Example: Suzy has property with a $100,000 cost and a $250,000 market value. If she sells the property she will pay tax of 15% on her $150,000 gain, which amounts to $22,500. After paying tax, Suzy only has $227,500 of the proceeds left to purchase new property. If Suzy can enter into a like-kind exchange, she can defer paying tax and will be able to acquire new property worth the $250,000 value of her old property.
With a like-kind exchange, tax is deferred rather than avoided. When a taxpayer exchanges a property, the original cost of the old property is applied to the new property.
Example: Barney owns Parcel 1 which he bought for $100,000 but is now worth $250,000.. Andy owns Parcel 2, which he bought for $120,000 but is now worth $250,000. They exchange properties. Barney now owns Parcel 2, with a cost of $100,000 and a market value of $250,000. Andy now owns Parcel 1 with a cost of $120,000 and a market value of $250,000. Neither pays tax at the time of the exchange. However, tax is not permanently avoided because Barney will have a taxable gain of $150,000 when he later sells Parcel 2 and Andy will have a taxable gain of $130,000 when he later sells Parcel 1.
To fully defer tax, no cash or assets other than the exchanged properties can change hands. If cash (including relief from debt) changes hands, taxable gain may be recognized to the extent of cash and other assets received. Cash and other assets received in a like-kind exchange are referred to as “boot”.
Example: Barney owns Parcel 1 which he bought for $100,000 but is now worth $250,000. Andy owns Parcel 2, which he bought for $120,000 but is now worth $230,000. They exchange properties and Andy pays Barney $20,000 because his property is worthless than Barney’s. Barney’s economic gain is $150,000, but his taxable gain is limited to the $20,000 cash he received. Andy’s exchange is still completely tax deferred because he received no boot.
Example 2: Barney owns Parcel 1 which he bought for $100,000 but is worth $250,000. Assume Barney has a $20,000 mortgage on Parcel 1. Andy owns Parcel 2, which he bought for $120,000 but is worth $230,000. They exchange properties and Andy assumes Barney’s $20,000 mortgage. Since Barney was relieved of the $20,000 mortgage, he has received boot. Barney’s economic gain is $150,000, but his taxable gain is limited to the $20,000 mortgage relief he received. Andy’s exchange is still completely tax deferred because he received no boot.
The basis of the new property is equal to the basis of the old property:
- Plus boot paid
- Less boot received
- Plus gain recognized
For both of the above 2 examples, Barney’s basis in Parcel 2 is:
Basis of Parcel 1: $100,000
Plus boot paid: $0
Less boot received: ($20,000)
Plus gain recognized: $20,000
Basis of Parcel 2: $100,000
If Barney immediately sells Parcel 2 for $230,000, he will recognize a gain of $130,000 ($230,000 sales price less basis of $100,000). When you add this $130,000 gain on sale to the $20,000 gain Barney recognized when he received the $20,000 boot, you have $150,000 which is the economic gain Barney had in Parcel 1. Notice how the economic gain of $150,000 is taxed as Barney received cash of $20,000 during the like-kind exchange, and $130,000 when he sells Parcel 2 for cash.
For both of the above 2 examples, Andy’s basis in Parcel 1 is:
Basis of Parcel 2: $120,000
Plus boot paid: $20,000
Less boot received: $0
Plus gain recognized: $0
Basis of Parcel 1: $140,000
If Andy immediately sells Parcel 1 for $250,000, he will recognize a gain of $110,000 ($250,000 sales price less basis of $140,000). This is the economic gain he had in Parcel 2.