Like-kind exchanges: follow all rules carefully
Apr 21, 2011
If you sell commercial or investment real estate that has appreciated significantly, one way to defer a tax bill on the gain is with a “like-kind” exchange. But these transactions must be structured carefully. One Tax Court case shows how a couple tried to engage in a swap, but since they didn’t comply with all the rules, the swap did not qualify for like-kind exchange treatment.
A like-kind or Section 1031 exchange of investment or business property allows a taxpayer to acquire another property in a new location-- or a different type of property-- without paying tax on the gain. With these transactions, a taxpayer can defer paying a tax bill and not tie up his or her money.
For example, let’s say someone purchased a small strip shopping center 20 years ago. He’s moving out of state and wants an income property that requires less work. If the client sells the center, he may have long-term capital gain of hundreds of thousands of dollars, and he’ll have unrecaptured Section 1250 gain, leaving him with a lot less cash to reinvest in a new property. A like-kind exchange allows the client to defer the gain indefinitely until the property is ultimately sold.
There are two basic ways to complete a like-kind transaction. You can find a property you want and exchange your property for it. But that’s unlikely because it’s difficult to find another real estate investor who wants to make an exchange of suitable property at the same time you do. There’s a second, more common approach.
For a number of years, the IRS has allowed a deferred exchange through the use of qualified escrow accounts or qualified intermediaries. In a typical situation, the property is sold with a qualified intermediary receiving the proceeds. The intermediary then acquires replacement property the taxpayer designates and transfers that property to the taxpayer. The key: the taxpayer cannot have control over the funds.
In one Tax Court case, the property owners did not follow all the rules so their exchange did not qualify for tax-favored treatment.
Facts of the case: Ralph Crandall and Dene Dulin sold an undeveloped parcel of property in Arizona that they held for investment. The taxpayers tried to engage in a like-kind exchange to acquire property in California. After receiving some limited advice concerning a tax-free exchange of properties, the taxpayers took steps to sell the Arizona property and purchase a new property with the intention of executing a tax-free exchange.
They sold the Arizona property for $76,000. The buyers paid $10,000 and the remaining $66,000 was placed in an escrow account with a title company. At the taxpayer’s direction $61,743 was held in the escrow account but later transferred to a second title company to purchase the replacement property. The escrow agreements did not reference a like-kind exchange, nor did they expressly limit the taxpayer’s “right to receive, pledge, borrow, or otherwise obtain the benefits of the funds,” according to the Tax Court.
To qualify as a deferred exchange, the court noted, the transaction must be an exchange of property, not a transfer of property for money. The reinvestment of cash proceeds from one property into a second property will not qualify as a Section 1031 exchange. Gain or loss may be recognized if a taxpayer actually or constructively receives money before receiving like-kind property.
To avoid being in constructive receipt of money or property, a taxpayer must use a qualified escrow account. But in this case, the taxpayers had control of the funds. The court held the transaction did not qualify for like-kind exchange treatment. (Ralph E. Crandall Jr. and Dene D. Dulin, T.C. Summary Opinion 2011-14)
The dollar amounts involved in this Tax Court case were relatively small. More often, the amounts in real estate transactions are much larger. This is one of those times when taxpayers want to make sure they follow all the requirements carefully. Fortunately, there are many qualified intermediaries who know the rules and will help ensure compliance. Moreover, the fee for the service is usually minor.
Even with the use of a qualified escrow account or intermediary, not all exchanges qualify. Here’s a short checklist of the basics:
• The property a taxpayer is disposing of and the one he or she is acquiring must be held for investment or for productive use in a trade or business. A rental property or vacant land held for appreciation qualifies; a principal residence or a vacation home does not.
• The property disposed of and the one acquired must be like-kind. When dealing with real property, most property qualifies, but the rules are much stricter for other property. A truck and an auto, both used in a business, aren’t like-kind. (The like-kind exchange rules generally don’t apply to stocks, bonds, etc.)
• The receipt of some unlike property (transferring a property for cash and another property) doesn’t disqualify the transaction, but could generate taxable gain.
• If the exchange is not simultaneous, a taxpayer must identify the replacement property within 45 days after transferring the relinquished property and receive the replacement property within 180 days (or, if earlier, the due date of the taxpayer’s return).
• If the property a taxpayer is exchanging is encumbered by a mortgage, and he or she is relieved of the debt, the rules are more complicated.
• Special rules apply to transactions between related parties.
They may have other options. Another approach is a “reverse-Starker” exchange or “parking transaction” where a taxpayer acquires the replacement property first. And, while deferring the gain is generally a smart move, there are situations where clients may want to recognize all or part of the gain immediately.
For help
As always, if you have questions, contact us via email or 410.685.5512. We are here to help.
