What is the Like-Kind Exchange?
Like-kind exchange, also known as the 1031 exchange, is a transaction or a combination of transactions that prevents the current tax liability under the United States Tax Laws on the sale of an asset because another similar asset is acquired in place of the existing asset.
A like-kind exchange is a transaction to defer the capital gain tax arising in the transaction of sale of an asset when it can be shown that the proceeds are being used to acquire another asset in the place of the first-mentioned asset. It is called the 1031 exchange because Section 1031 of the Internal Revenue Code exempts the seller of an asset when the proceeds of the sale are reinvested in assets of value equal or higher. An exchange will not be considered as a like-kind exchange if the asset being bought is the personal property of the seller. In all other cases, this would apply.
- The replaced property or asset must be of similar nature and character to be qualified as a like-kind exchange.
- Another important feature is that one property or asset can be a like-kind asset to more than one property. The Internal Revenue Service says that 3 properties can be designated as long as they can be closely identified.
- Timing rules apply to the deferred exchanges strictly, i.e., Within 180 days of the transfer of the relinquished property, the taxpayer must receive the replacement property.
Types of Like-Kind Exchange
Broadly there are 4 types of a like-kind exchange. Namely, simultaneous exchange, delayed exchange, reverse exchange, and continuous or improvement exchange.
#1 – Simultaneous
In such cases, the property being sold and the property being acquired are exchanged on the same day. That means the transaction is closed on the same day. Further, there are three ways in which this simultaneous trade can also happen
- Two-party trade swapsTrade SwapsSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.
- Three-party exchange
- Simultaneous exchange involving an intermediary.
#2 – Delayed
It is the most common and preferred type of exchange. In this type, the owner of the asset sells it and then acquires the replacement property within the time frame (45 days for identifying the property to be acquired and 180 days to complete the sale).
#3 – Reverse
It is also known as a forward exchange wherein the property which has to be acquired as a replacement is acquired in advance, i.e., the property is bought first and exchanged later.
#4 – Construction or Improvement Exchange
Improvements to the property can be made using the tax-deferred dollars for enhancement of the same while placing the property in the hands of a qualified intermediary within 180 days.
How Does it Work?
Usually, when a property is being bought or sold, the gain realized in the process is chargeable to capital gains tax, and depending on the period of holding, they are charged with long term capital gain tax or short term capital gain tax. Sometimes, a property is sold with an intention to buy another property in its place, i.e., the old property is just being replaced. So as to cover such transactions, Sec 1031 of the IRC exempts transactions in the name of Like-Kind Exchange.
Let us consider an example of Mr. A, who wants to sell his commercial property for $500,000, which was originally acquired for say, $300,000. This transaction would lead to a profit of $200,000, which would be subject to tax. But, if Mr. A does a 1031 exchange, he can defer this tax by replacing the sold property by another property similar in nature and character (with a 45-day and 180-day period as mentioned in rules below).
Rules of Like-Kind Exchange
There are 7 primary rules. They are as follows:
- The assets or properties being bought and sold, i.e., the exchange must be like-kind, i.e., identical in nature and character.
- It is applicable only when an investment or business property is involved.
- The property being acquired from the proceeds shall be either of the same value or higher.
- Any boot arising as a result of exchange shall be subject to capital gains tax.
- The taxpayer must be the same, i.e., the buyer of the replacement property and seller of the relinquished property must be the same.
- The property must be identified within 45 days.
- The property must be purchased with 180 days.
Like-Kind Exchange vs. Opportunity Zone
|Point of Difference||Like-Kind Exchange||Opportunity Zone|
|Property||The property must be of similar nature and/or character.||The property does not have to be of like kind.|
|Identification of the like- property||Within 45 days||No such time frame|
|Investment||Entire sale proceeds must be invested.||Only the gain on the sale must be reinvested.|
|Purchase of: Personal Property, Stocks, Partnership Interests, etc.||Not allowed||Allowed|
- The very purpose of the introduction of this kind of exchange is to avoid paying capital gains tax, and the proceeds of a sale are untouched before they are reinvested, allowing the earning power of the deferred income taxDeferred Income TaxDeferred income tax is a balance sheet item that can be either a liability or an asset since it is a difference in income recognition between the firm's accounting records and the tax law, resulting in the company's income tax due being different than the total tax expense reported..
- The very basic advantage would be that of leverage. With the proceeds obtained from the sale, one can buy a more valuable investment propertyInvestment PropertyInvestment property refers to the real estate acquired to earn returns on the investment through rental income, royalties, dividends or future appreciation, usually in the name of an individual investor, a group of investors or an investment company for a short-term or a long-term investment..
- The major disadvantage is the term period of 45-day and 180-day, which is strict. Failure to take ownership will result in a failed transaction. Identifying the replaced asset, which is similar and has a value equal or greater than the replenished asset.
All said, the bottom line is that when one wants to sell an asset to buy another asset in its place, one should look at the rules mentioned in the 1031 exchange. If the rules are in line with the facts of the individual case, there would be tax benefit that could arise. Of course, there are many pros and cons, and a decision has to be taken, keeping in mind all the factors mentioned.
This article has been a guide to what is the Like-Kind Exchange. Here we discuss types, rule, and how does like-kind rule work along with an example, advantages and disadvantages. You can learn more about financing from the following articles –