In the current real estate market, many investors selling properties are receiving offers well above the list price and original purchase price. At face value, this is great. Investors are receiving large returns on their investments. However, the downside to this great return is the large tax gains on these sales. If the taxpayer sells for a higher value than the original purchase and they’ve received ordinary tax benefits through depreciation, they could face a significant tax bill. This tax gain could ultimately negate the large cash deposit received when selling the property.
One way to defer a potentially large tax gain is a like-kind exchange. These exchanges have garnered popularity over the years due to the increase in the value of real estate. Like-kind exchanges, when done correctly, can allow the taxpayer to defer their tax gain while buying new real estate in the process.
Key Exchange Rules
In order to complete a successful like-kind exchange and defer the tax gain, the taxpayer needs to follow a set of rules. If these guidelines are not met, the taxpayer will not qualify for gain deferral and will need to pay tax on the full value.
- Taxpayer must use a qualified intermediary – This individual sells the property on your behalf, collects the cash, and then uses that cash to purchase the new property. The intermediary must receive the cash from the closing, not the taxpayer, to qualify for gain deferral.
- 45 days to identify new properties – The taxpayer must identify the properties they would like to purchase within 45 days from the sale of the property. They do not need to purchase all of the identified properties, but the properties they purchase must be one of the ones identified.
- 180 days to close on new properties – The taxpayer has 180 days from the initial sale to close on the new properties that were identified. This timeline runs concurrently with the 45-day identification timeline.
Additional Requirements
If all the guidelines listed above are met the taxpayer is eligible to defer their tax gain. But in order to fully defer the gain, the taxpayer must meet further requirements.
- Purchase property of equal or greater value – The new property purchased needs to have a value similar or greater to the property sold.
- Incur debt of equal or greater value – Any debt paid off when the original property was sold needs to be incurred on the new property. This can be a new loan or new cash paid by the taxpayer
- Do not receive any cash – Taxpayer must use all the cash held by the intermediary to purchase the new property. Any cash received will be taxable.
If the replacement property meets all these requirements the full gain can be deferred. If any of these requirements are not met some of the gain could be taxable but would still qualify for a successful exchange.
Types of Exchanges
- Forward Exchange- The usual exchange occurs by the taxpayer selling their property and then purchasing a new property. Not all like-kind exchanges need to follow this structure. However, all like-kind exchange types do need to meet the previously explained rules and requirements to qualify for full gain deferral
- Reverse Like-Kind Exchange- The taxpayer may find the property they want to purchase before they sell their existing property. Reverse like-kind exchanges require the taxpayer to follow a few additional rules. Taxpayers cannot own the new property and original property at the same time. This requires the taxpayer to work with a qualified intermediary and exchange accommodation titleholder to purchase the new property. Then the property to be sold must be identified within 45 days and sold within 180 days. Once the property is sold the intermediary uses the funds to pay off any loans on the new property and then transfers the title to the taxpayer.
- Improvement Exchange- A taxpayer may want to purchase a new investment property that needs significant improvements or a fully new building and include the improvement costs in the like-kind exchange. Improvement exchanges can be forward or reverse exchanges. These exchanges are more difficult because the improvements and/or construction must be completed within the 180-day timeframe to qualify the costs in the exchange. This does not mean the full construction needs to be completed in 180 days, but only the improvements completed within that timeframe qualify.
Final Thoughts
Like-kind exchanges can be great tax deferral strategies to help real estate investors defer the tax impact of selling property while also building and diversifying their portfolio. These exchanges have many rules and requirements that need to be followed to ensure the gain is fully deferrable. Which is why it’s important to consult a qualified tax advisor when looking to completing one of these exchanges.
Sarah Fordyce is a senior tax manager specializing in real estate for 1RDG, the financial center, which provides businesses with a full range of management, compliance, and advisory services. For more information, please visit 1RDG.com.