Wednesday, April 9, 2014
Blog Post #2
Like-kind Exchanges for Real Estate Investors
By Dennis Glukhoy
What are Like Kind Exchanges?
Investors who sell or exchange property for an amount greater or less than their basis in that property have a realized gain or loss on the sale or exchange. The realized gain or loss must be recognized (reported on the taxpayer’s tax return) unless there is a code section specifically for nonrecognition treatment. This is where the 1031(a) section code applies. The gain or loss is not recognized at the time of the transaction and instead may be deferred if the exchange occurs between like-kind properties. Congress allows this because the taxpayer has continued the investment and has never received the proceeds.
Note: Section 1031 is not an elective provision, meaning if the exchange qualifies as a like-kind, nonrecognition of gain or loss is mandatory.
Dennis owns an apartment held for investment. Dennis exchanges the building for farmland to be used in his trade or business. The exchange is a like kind exchange because both the building and the farmland are classified as real property and both properties are used either in business or held for investment. No gain or loss is recognized by Dennis.
What are the requirements?
1) Like-kind for like kind: real estate for real estate (regardless of type, but not USA to foreign)
2) Business or income producing use for business or income producing use: only applies to the use of the taxpayer and not the other party. If the property is the for taxpayer personal use it does not qualify.
3) Exchange means: Cannot cash cash out and then re-buy. The taxpayer cannot have actual or constructive receipt of proceeds. The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable. A like-kind exchange would involve either use of a simultaneous exchange which would likely involve three parties or two parties (simply swapping properties but not always practical) or a non-simultaneous exchange where the buyer needs to identify the property to be received within 45 days after the date of the transfer of the property relinquished in the exchange. The replacement property must be received within 180 days of the date the original property was relinquished.
What are the benefits?
By deferring paying capital gains taxes you give yourself more investing leverage. For instance if you were purchasing a replacement property (without the benefit of a 1031 exchange) your buying power is reduced to the point, that it only represents 70-80% of what it did previously (before the exchange and payment of taxes). An 1031 exchange where the investor was able to defer virtually all of their capital gains would act almost as if the investor were to receive an interest free, loan from the government. Another reason an investor should consider a 1031 would be if they were planning to relocate and wanted to find a similar property in the same area.
The cherry on top!
Benjamin Franklin once said that “in this world nothing is certain, except death and taxes.” Well I have great news for you! And no, I haven’t figured out a way of cheating death just yet but in regards to taxes a 1031 exchange can make it so that your heir and future generations may never have to pay a part of the capital gains you would otherwise have had to recognize. Should the investor die, the cost basis of the last property would be adjusted to fair market value on the date of the decedent’s death. Your heirs would not be liable for those accumulated capital gains taxes. Mr. Franklin would have been very happy!
"The 1031 Exchange for Real Estate Investors." About.com Real Estate Business. N.p., n.d. Web. 08 Apr. 2014.
Prentice Hall's Federal Taxation 2014, Comprehensive. N.p.: Pearson College Div, 2013. 12-4:12-6. Print.