Like-Kind Exchange Basics
Many people are familiar with a Like-Kind Exchange (LKE) as a strategy to potentially save taxes on the sale of real estate. While it is true LKEs can be used to defer significant taxes, the process required to implement LKEs it often not well understood. The following are answers to a few of the more common questions about LKEs. A better understanding of LKEs may help you determine if a LKE may be an option for your next real estate transaction.
What Property Can Be Exchanged?
Prior to January 1, 2018, many different types of property could be exchanged including machinery and livestock. The 2018 Tax Cuts and Jobs Act restricted the type of property allowed for a LKE to only real estate. Fortunately, real estate is defined broadly in the context of a LKE. Real estate used in a LKE are subject to the following rules:
- Must be held for business or investment purposes but does not need to be similar in grade or quantity
- Primary residences do not qualify
- Properties must be held in the United States
Other than personal residences, almost any other type of real estate can be exchanged. For example, an office building can be sold and the proceeds used to buy farmland. These two very different types of real estate would likely qualify for a LKE provided they are held for business or investment purposes.
Are There Different Types of LKEs?
There are generally three different types of LKEs. The first is a simultaneous trade which involves one owner exchanging their real estate for real estate owned by another. The exchange occurs by the owners executing deeds transferring their real estate to each other. For example:
Andy owns farmland in Ohio valued at $1 million. He makes a deal with his friend Ashley. Andy will trade his farmland for Ashley’s farmland in Illinois valued at $1 million. Andy executes a deed transferring his farmland to Ashley and Ashley executes a deed transferring her farm to Andy.
The above example shows how a simultaneous trade works. The parties simply swap their property.
Another type of LKE is a deferred exchange. This strategy involves selling real estate, then using those proceeds to buy replacement real estate. The following is an example of a deferred exchange:
Andy owns farmland in Ohio valued at $1 million. He decides he wants to buy farmland in Illinois. Ashley wants to sell her farmland for $1 million. Andy sells his farmland in Ohio and uses those sale proceeds to purchase Ashley’s land for $1 million. Andy will not pay tax on the sale of the Ohio farmland because he purchased a replacement property. Ashley will pay tax on her sale because she did not purchase a replacement property.
The other type of LKE is a reverse exchange. This LKE is used when the replacement property is purchased first and then the owned real estate is sold. This strategy is used when, due to timing, the replacement property must be purchased before the relinquished property is sold. The following is an example of a reverse exchange:
Same facts as above except that the farm in Illinois that Andy wants to buy is going to sell next week. Andy does not have time to sell his Ohio farm first. Andy buys the Illinois farm first using cash from his savings. Andy essentially loans $1 million to the title company. The title company takes title to the Illinois land and holds until Andy can sell the Ohio land. Two months later he sells the Ohio farm and uses those sale proceeds to pay for the Ohio property with the original loaned funds being returned to Andy.
A reverse exchange is complicated and usually requires the assistance of companies that specialize in LKEs. Furthermore, the person doing the reverse exchange must have enough money available to purchase the replacement property while waiting on the owned property to sell.
Are Taxes Avoided with a LKE?
Technically, taxes are deferred with a LKE. The reason it is a deferral of taxes is that the tax basis follows the taxpayer. This can best be explained using an example:
Andy paid $300,000 for a farm he owns in Ohio. The Ohio farm is currently valued at $1 million. He has decided that he wants to purchase a farm in Illinois valued at $1 million. He executes a LKE by selling the Ohio farm and purchasing the Illinois farm. The tax basis in the Ohio farm of $300,000 is transferred to the Illinois farm. So, instead of the Illinois farm having a tax basis of the purchase price ($1 million), it has a tax basis of $300,000. If Andy sells the Illinois farm, he will pay capital gains tax on the sale price exceeding $300,000. Therefore, the tax implications of the LKE were deferred until the Illinois property is sold by causing the tax basis of the Ohio farm to transfer to the Illinois farm.
As the above example shows, a LKE defers capital gains tax but does not necessarily eliminate taxes. By transferring the tax basis from the relinquished property to the replacement property, the capital gains will be fully realized upon the sale of the replacement property.
What if the Properties are not the Same Value?
Properties being exchanged are rarely the same value and some money may need to be paid to offset the difference in value. Because money is not eligible for a LKE, that portion of the exchange will be taxable. Consider the following example.
Andy owns a farm valued at $1.2 million and intends to participate in a simultaneous exchange for a farm valued at $1 million owned by Ashley. Andy will receive Ashley’s property plus $200,000. The LKE will defer taxes on the $1 million property received but Andy will pay tax on the $200,000 payment.
Is Timing important for LKEs?
Timing is very important for a LKE. A simultaneous exchange, as the name would suggest, must occur by transferring the properties at the same time. For a deferred exchange, the replacement property must be identified within 45 days of the sale and the replacement property must be purchased with 180 days of the sale. For a reverse exchange, the relinquished property must be sold within 180 days of the purchase. There is no flexibility with these deadlines, if a deadline is missed the LKE is not allowed.
Who Can Participate in an LLC?
In a LKE, the same person must be on both sides of the exchange. A person can be a business entity, trust, or estate in addition to an individual. This rule can be an issue when a business entity owns the property because the entity, and not the individual owners, must complete the exchange. For example:
Andy and Ashley are the owners of AB Farms LLC that owns Blackacre farm. They decide to sell Blackacre farm. Only AB Farms LLC is eligible to use the sale proceeds in a LKE. Neither Andy nor Ashley can take their share of the sale proceeds and participate in a LKE.
Another issue may be related parties. Related parties are defined in IRS sections 267(b) and §707(b)(1) and are generally brothers, sisters, spouse, ancestors and lineal descendants for individuals and for business entities with more than 50% of the stock, membership interests or partnership interests owned by a related party. Some types of LKEs are not available to related parties and for other LKEs there are special rules for related parties. The details for related parties are extensive LKEs are beyond the scope of this article. Be sure to work with an attorney familiar with LKEs when related parties are involved.
Who Handles the Money?
In a deferred exchange, the sale proceeds cannot be held by the seller. An intermediary, usually a title company, will hold the money in escrow after the property is sold and before the replacement property is purchased. Any sale proceeds held by the seller are immediately ineligible for a LKE. In a reverse exchange, an intermediary holds the purchased real estate until the relinquished property is sold. In a deferred exchange or reverse exchange, the intermediary serves a vital and necessary role.
The above questions and answers are some of the more common questions with general answers. There are many rules, exceptions and details in addition to the issues discussed in this article. Before engaging in a LKE, be sure to consult with an attorney familiar with LKE rules. You only get one chance to get a LKE right, any missteps will likely cause the LKE to fail and tax will be owed on the exchange.
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