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Slash Taxes By Swapping Like-Kind Assets

Did you know you can defer taxes by trading business equipment or investment real estate? Selling, of course, would trigger capital gains tax on the asset’s appreciation, plus a 25% levy on all the depreciation you previously deducted (known as depreciation recapture). But Section 1031 of the tax code allows you to defer taxes by swapping for similar, or “like-kind,” property.

A 1031 exchange is not literally a trade. In most cases, you sell the asset to one party and buy its replacement from someone else, with a professional intermediary assisting you. There are several requirements.

  • You must have held the asset you’re exchanging for more than one year.
  • U.S. property must be traded for U.S. property, foreign for foreign.
  • You can’t swap securities or inventory.
  • Ownership title on the new and old assets must be identical.

In addition, be aware of the following.

  • Trading up to a pricier asset can increase your depreciation deduction.
  • Only part of the tax is deferred when: 1) the replacement property is cheaper; 2) you receive cash or property that isn’t like-kind as part of the deal; or 3) the amount you finance on the new asset is less than you owed on the old.

You can perpetuate this tax-deferral through a series of successive 1031 exchanges, with no tax due until you sell the final asset in the chain. And if you die holding property received in a 1031 exchange, all appreciation is forgiven, and your family can avoid paying all the tax you’ve deferred. The asset’s full market value at your death becomes your heirs’ cost basis.

What is “like-kind”?Under the rules, business equipment must be of the same nature or character, although the grade or quality can differ. In other words, you can exchange your business’s old truck for a new, bigger one, but not for a security system. Livestock must be of the same gender.

However, all income-generating real estate is virtually interchangeable. You could swap fallow farmland for rental property to increase current income, or an expensive rental for several modest ones to diversify your holdings. You could even exchange a duplex you personally manage for an ownership interest in a professionally-maintained apartment high-rise, according to a 2002 IRS pronouncement.

When a personal residence is involved.Using your residence partly for business or turning your home into a rental makes the property eligible for a 1031 exchange and could transform tax deferral into tax elimination. The rule that lets you exclude up to $250,000 of gain on your home from taxable income, or $500,000 if you file jointly, absorbs profit you would normally defer when exchanging commercial property. To get this benefit, you must have owned and used the property as your primary residence for at least two of the past five years.

Similarly, if you own rental property acquired in a 1031 transaction, converting it into your home could prevent the deferred taxes from ever coming due. Under a 2004 law, you can take advantage of the home-profit exclusion by selling the property after you have owned it for five years, having lived there two of those five. You also must have acquired the property not intending to convert it to personal use, although the IRS hasn’t stipulated how long it has to remain non-personal.

Making the exchange.Within 45 days of selling a property, you must identify potential replacements, then buy from that list within 180 days of the sale (or by the extended due date of your tax return, if that’s sooner).

A cardinal rule is that you can’t touch the proceeds from the sale of the old property. That’s where the qualified intermediary comes in. This professional, sometimes known as an accommodator or facilitator, attends the sale closing in your place, relinquishing your property to the buyer and holding the proceeds in escrow until they are used to purchase the like-kind asset. Some facilitators help locate replacement property. In practice, reverse exchanges are also allowed; you can purchase the replacement property first, then sell a like-kind asset you own.

IRS rules regarding 1031 exchanges are complex and this strategy is only suitable for certain individuals. Because a mistake could trigger immediate tax on the sale, it’s essential to use an experienced intermediary who can help you reap full benefits.

 


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.



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