The Benefits of Like-Kind Exchanges

Normally, when you sell real estate for more than you paid for it, you pay tax on the gain at the time of sale, even if you plan on reinvesting the proceeds in another property.  The payment of tax on the gain, however, may not be necessary if you instead choose to exchange your property for a similar property. Such exchanges, called like-kind exchanges, allow you to postpone paying tax on the gain until a later time.

Requirements

These exchanges must meet the formal requirements found in Section 1031 of the Internal Revenue Code, which is why they are sometimes referred to as 1031 exchanges.  The main requirements are as follows:

• You must exchange your real estate, not sell it, for another one.
• You must hold both the property traded and the property received for business or investment purposes.
• The properties must be of similar nature, character, or class, regardless of quality or grade. For example, improved real estate can be traded for unimproved real estate.
• The properties must not be held primarily for sale, such as inventory.

Benefit

Section 1031 allows you to postpone paying tax on the gain if you reinvest the proceeds in a similar property.  At the time of transfer, taxable gain and the consequent capital gains tax is deferred until a later sale.

Deferred-Exchange Example

If you purchased a tract of farmland for $100,000, and 15 years later you sold it for $150,000, you would typically have to pay capital gains tax on the $50,000 of built-in gain.  Instead, if you structured the sale as part of a 1031 like-kind exchange and purchased new farmland or pasture for $175,000, no tax would be paid.  Your new basis in the purchased property would be $125,000 – your $100,000 basis from the previous property plus the additional $25,000 cash paid.

The attorneys at Clark, Mize & Linville, Chartered can help you thoroughly understand like-kind exchanges and choose whether a “simultaneous” exchange, traditional “deferred” exchange, or a “reverse” exchange will best meet your needs.  Even though the structure of like-kind exchanges can be complex, the benefit of the tax deferral often makes the process worthwhile.

Written by:  Joshua C. Howard 

Related Practice Areas:   Business Formation and Governance and Real Estate Law