The exchange of real property for other real property (a “like-kind” exchange) may be a nontaxable event. To be a like-kind exchange, the property you transfer (the “Exchange Property”) and the property you acquire (the “Replacement Property”) must be both (1) “qualifying” property and (2) “like” property.
Additional requirements apply to like-kind exchanges in which the Replacement Property is not acquired immediately upon the transfer of the Exchange Property. If you have already found a house to purchase, but have not found a buyer for your property, read about a Reverse Exchange.
Important: If the like-kind exchange includes the receipt of money or unlike property or the assumption of liabilities, any gain realized in the transaction may be taxable.
In a like-kind exchange, the basis of the Replacement Property is the same as the basis of the Exchange Property, plus any money paid or unlike property given in the transaction.
A like-kind exchange is reported on IRS Form 8824. The instructions for the form explain how to report the details of the exchange. The like-kind exchanged must be reported even though no gain or loss is recognized.
Any gain realized in an otherwise tax-free exchange of like-kind property, which is taxable because of the receipt of money or unlike property, is reported on Schedule D (Form 1040) or Form 4797, whichever applies. All or a portion of such taxable gain may have to be reported as ordinary income under the depreciation recapture rules.
Closing costs, such as brokerage commissions, attorney fees and document preparation fees, associated with the transfer of the Exchange Property are subtracted from the consideration received to figure the amount of gain realized on the transfer of the Exchange Property. For the Replacement Property, these expenses are added to basis.
In a like-kind exchange, both the Exchange Property and the Replacement Property must be held for investment or for productive use in a trade or business.
The rules for like-kind exchanges do not apply to exchanges of the following real property:
* Real property used for personal purposes, such as your home or vacation property
* Stock in trade or other property held primarily for sale, such as real estate held by dealers
*Securities of real estate investment trusts
* Partnership interests, even if the partnership’s sole asset is real estate
* Certificates of trust or other beneficial interest in real estate. However, other Internal Revenue Code provisions may afford nontaxable treatment for these transactions. An exchange of the assets of a business for the assets of a similar business cannot be treated as an exchange of one property for another property. Whether you have engaged in a like-kind exchange depends on an analysis of each asset involved in the exchange.
There must be an exchange of like property. Generally, the exchange of any type of real estate for any other type of real estate is an exchange of like property. An exchange of personal property for real property does not qualify as a like-kind exchange.
For example, the trade of land improved with an apartment house for land improved with a store building is a like-kind exchange. Similarly, an exchange of city property for farm property, or improved property for unimproved property, can qualify as a like-kind exchange. The exchange of fee simple real estate for a real estate lease that runs 30 years or more is also a like-kind exchange. However, not all exchanges of interests in real property qualify. The exchange of a life estate expected to last less than 30 years for a remainder interest is not a like-kind exchange. An exchange of a remainder interest in real estate for a remainder interest in other real estate is a like-kind exchange if the nature and character of the two property interests are the same.
Foreign real property
Real property located in the United States and real property located outside of the United States are not considered like-kind property under the like-kind exchange rules. Foreign real property is real property not located in a state or the District of Columbia.
This foreign real property exchange rule does not apply to the replacement of condemned real property. Foreign and U.S. real property can still be considered like-kind property under the rules for replacing condemned property to postpone gain on the condemnation.
A deferred exchange (also referred to as a “Starker Exchange”) is one in which the Exchange Property is transferred and, at a later time, the Replacement Property is acquired. The transaction must be an interrelated exchange (that is, real estate for real estate), rather than a transfer of the Exchange Property for money or unlike property actually or constructively received by you, even if that money is later used by you to purchase the Replacement Property. In the latter case, the transaction in which the Exchange Property is transferred will be treated as a sale rather than a deferred exchange.
Actual or constructive receipt of money or unlike property occurs if, at the time of the transfer of the Exchange Property, the money or property is credited to your account or otherwise made available to you. You are also in actual or constructive receipt of money or unlike property at the time any limits or restrictions on it expire or are waived.
Like-kind Exchanges using qualified intermediaries
A like-kind exchange may be accomplished through a “qualified intermediary.” A qualified intermediary is a person who:
1. Enters into a written exchange agreement with you to acquire and transfer the Exchange Property and to acquire the Replacement Property and transfer it to you. This agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary.
2. Is neither of the following:
(a) Your agent at the time of the transaction. This includes a person who has been your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period before the transfer of the Exchange Property.
(b) A person who is related to you or your agent.
An intermediary is treated as acquiring and transferring the Exchange Property if:
1. The intermediary acquires and transfers legal title to the property,
2. The intermediary enters into an agreement with a person other than you for the transfer to that person of the Exchange Property and that property is transferred to that person, and 3. The intermediary enters into an agreement with the owner of the Replacement Property for the transfer of that property and the Replacement Property is transferred to you.
An intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment by the date of the relevant transfer of property.
You must identify the Replacement Property within 45 days after the date of the transfer (i.e., the settlement) of the Exchange Property. Any Replacement Property acquired during that time is considered to have been identified by you.
If more than one Exchange Property is transferred (as part of the same transaction) and the properties are transferred on different dates, the identification period and the receipt period begin on the earliest date of the transfers.
The Replacement Property must be identified in a signed written document delivered to the other person involved in the exchange or the intermediary. You must clearly describe the Replacement Property in the written document, such as its legal description or street address. In the same manner, you can revoke an identification of Replacement Property at any time before the end of the identification period.
You can identify more than one Replacement Property. Regardless of the number of Exchange Properties, the maximum number of Replacement Properties you can identify is:
2. Any number of properties whose total fair market value (FMV) at the end of the identification period is not more than double the total FMV, on the date of transfer, of all Exchange Properties.
If, as of the end of the identification period, you have identified more properties than permitted under this maximum rule, the only property that will be considered identified is:
* Any Replacement Property you acquired before the end of the identification period, and
* Any Replacement Property identified before the end of the identification period and received before the end of the receipt period, but only if the FMV of the property is at least 95% of the total FMV of all identified Replacement Properties. (Do not include any you revoked.) FMV is determined on the earlier of the date you acquired the Replacement Property or the last day of the receipt period.
If your identified Replacement Property is real property to be improved and it is not completed by the date you acquire the property, it may still qualify as like-kind property. It will qualify as like-kind property only if, had it been completed on time, the Replacement Property would have been considered to be substantially the same as the property you identified. It is considered to be substantially the same only to the extent the property received is considered real property under local law. However, any additional improvements to the Replacement Property after you acquire it do not qualify as like-kind property. To this extent, the transaction is treated as a taxable exchange of property for services.
The Replacement Property must be received by the earlier of:
* The 180th day after the date on which you transfer the Exchange Property, or
* The due date, including extensions, for your tax return for the tax year in which the transfer of the Exchange Property occurs.
You must receive substantially the same property that met the identification requirement, discussed earlier.
Partially non-taxable exchanges
If, in addition to like property, you receive money or unlike property in a like-kind exchange in which you realize a gain, you have a partially nontaxable exchange. You are taxed on the gain you realize, but only to the extent of the money and the fair market value of the unlike property you receive. A loss is never deductible in a nontaxable exchange even if you receive unlike property or cash.
To figure the amount of taxable gain, first determine the fair market value of any unlike property you receive and add it to the amount of any money you receive. The total is the maximum amount of gain that can be taxed. Next, figure the amount of gain on the whole exchange. Your recognized (taxable) gain is the lesser of these two amounts.
Example: You exchange real estate held for investment that has an adjusted basis of $180,000 for other real estate that you plan to hold for investment. The real estate you acquire has a fair market value of $200,000. You als receive $10,000 in cash. You paid $5,000 in exchange expenses. Although the total gain realized on the transaction is $25,000, only $5,000 ($10,000 cash received minus the $5,000 exchange expenses) is recognized (i.e., included in your income).
Assumption of liabilities
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.
Example: The facts are the same as in the previous example, except the property you give up is subject to a $20,000 mortgage. Figure the gain realized as follows:
|FMV of Replacement Property||$200,000|
|Mortgage on Exchange Property||$20,000|
|Minus exchange expenses:||$-5,000|
|Minus adjusted basis of exchange property||$-180,000|
The realized gain is taxed only up to $25,000, the sum of the cash received ($10,000 – $5,000 exchange expenses) and the mortgage ($20,000).
Basis of property received
The total basis for all Replacement Properties you acquire in a partially nontaxable exchange is the total adjusted basis of the Exchange Properties, with the following adjustments:
(a) Any additional costs you incur, and
(b) Any gain you recognize on the exchange, and
(a) Any money and the FMV of any unlike property you receive
Like-kind Exchanges between related parties
Special rules apply to like-kind exchanges made between related parties. These rules affect both direct and indirect exchanges. Under these rules, if either party disposes of the property within 2 years after the exchange, then the exchange is disqualified from nonrecognition treatment. The gain or loss on the original exchange must be recognized as of the date of that later disposition.
Under these rules, related parties include, for example, you and a member of your family (spouse, brother, sister, parent, child, etc.), you and a corporation in which you have more than 50% ownership, you and a partnership in which you directly or indirectly own more than a 50% interest of the capital or profits, and two partnerships in which you directly or indirectly own more than 50% of the capital interests or profits.
The 2-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange. If the holder’s risk of loss on the property is substantially diminished during any period, however, that period is not counted toward the 2-year holding period. The holder’s risk of loss on the property is substantially diminished by:
* The holding of a put on the property,
* The holding by another person of a right to acquire the property, or
* A short sale or other transaction.
A put is an option that entitles the holder to sell property at a specified price at any time before a specified future date. A short sale involves property you generally do not own. You borrow the property to deliver to a buyer and, at a later date, buy substantially identical property and deliver it to the lender.
See I.R.S. Publication 544 (1997), Sales and Other Disposition of Assets