A like-kind exchange, or 1031 exchange, is used to defer the capital gain on the exchange of business or investment property for the same kind of property.
To qualify as a like-kind exchange, the property traded and property received must be both qualifying and like property.
Qualifying property is property held for investment or for productive use in your trade or business. Examples include machinery, buildings, trucks, rental houses, office equipment, etc.
Property is considered like property when real estate is exchanged for real estate or personal property is exchanged for personal property (e.g., the exchange of work trucks). You can exchange land for an office building or improved real estate for unimproved real estate. However, you cannot exchange real estate for tangible personal property such as machinery and equipment. Depreciable, tangible personal property can be either like-kind or like-class. Like-class means the property is in the same General Asset Class as defined by the IRS for depreciation of tangible assets. A partial list of General Asset Classes is presented below:
- Office furniture, fixtures, and equipment
- Information Systems, such as computers and peripheral equipment
- Data handling equipment, except computers
- Airplanes, except those used in commercial or contract carrying of passengers or freight, and all helicopters.
Note that a computer and office equipment are not like-class property.
A simple example of a like-kind exchange is found in IRS Publication 544, Sales and Other Dispositions of Assets: A cab driver trades in his old cab for a new one. The new cab costs $10,800. He is allowed $2,000 as trade-in value for his old cab and pays $8,800 cash. There is no taxable gain or deductible loss regardless of the basis of his old cab. The basis of his new cab simply becomes the basis of the traded in cab. Let’s say the old cab was fully depreciated for tax purposes so that the basis is $0. The cab driver has a realized gain of $2,000 (trade-in amount allowed less the basis), but the entire gain is postponed for tax purposes due to the like-kind exchange rules. The basis of the new cab is $8,800, or the cash paid. If the cab driver later sells the new cab for $10,800, then his taxable gain at that time would be $2,000 (Selling price minus the basis or $10,800-$8,800).
Partially Nontaxable Exchanges
If you receive cash or unlike property and you have a realized gain in a like-kind exchange, you have a partially taxable exchange. The realized gain is taxed to the extent of the money and fair market value of unlike property you receive. If you have a loss in a nontaxable exchange it is never deductible, even if you receive unlike property or cash.
A simple example involving the exchange of real estate will help explain partially taxable exchanges. Note that if the other party to a nontaxable exchange assumes any of your liabilities, or if you transfer property subject to a liability, you will be treated as if you received cash in the amount of the liability.
Fair Market Value of Real Estate Received
Mortgage Assumed on Property Given Up
Minus: *Exchange Expenses
Minus: Adjusted Basis of Property Given Up
The realized gain is only recognized up to the amount of the cash received and the mortgage assumed ($1,000 cash received – $500 in exchange expenses + $3,000 for the mortgage assumed) or $3,500.
*Exchange expenses may include closing costs such as brokerage commissions, attorney fees, and deed preparation fees.
If you give up like and unlike property, except cash, you must recognize a gain or loss on the unlike property given up. The gain or loss equals the difference between the fair market value of the unlike property and its adjusted basis.
A deferred exchange occurs when you transfer property held for investment or used in your business and at a later time you receive like-kind property or replacement property.
If you receive money or unlike property in full payment for the property transferred before receiving the replacement property, the transaction is treated as a sale. You must recognize a gain or loss on the sale, even if you later receive the replacement property. To qualify as a deferred exchange, the replacement property must be identified within 45 days after the date you transfer the property given up. Also, the replacement property must be received by the earlier of:
- The 180th day after the date on which you transfer the property given up, or
- The due date, including extensions, for your tax return for the tax year in which the transfer of property given up occurs.
Nontaxable exchanges can be quite complex and generally require the skills of an attorney that specialize in such transactions. Also, there are qualified intermediaries, such as some financial institutions, that assist with these transactions. If you would like further information regarding this topic or any other tax related issue, please contact Henssler Financial at 770-429-9166 or firstname.lastname@example.org.