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Like-Kind Exchanges: Tax Planning for 2022

like kind exchanges

The tax-deferred like-kind exchange has been around for more than half a century, and businesses in all types of industries have taken advantage of the incentive. But beginning in 2018, the tax law underwent a major change. When Congress passed the Tax Cuts and Jobs Act (TCJA), they disallowed all like-kind exchanges except for exchanges of real property.

Although this law change appears straightforward, taxpayers had a few questions. The IRS passed final regulations in December 2020 to answer them. With the new rules and regulations in mind, let’s discuss how we can utilize like-kind exchanges in your clients’ tax planning strategies.

What Are Like-Kind Exchanges?

Like-kind exchanges, which are also referred to as Section 1031 exchanges, are mechanisms taxpayers can use to defer capital gains on sales of certain assets. When selling qualifying property, taxpayers can defer their gain on that sale if they purchase similar property — property that is of like kind — within a certain period.

What Changed in 2018?

Originally, like-kind exchanges were available on almost all capital assets: real estate, machinery, vehicles, airplanes, warehouse equipment, office furniture, etc. However, when the TCJA was passed, like-kind exchanges became much more limited. Beginning in 2018, only exchanges of real property (i.e., buildings, land and improvements) can qualify for tax deferral under Section 1031.

How Can Your Clients Qualify for Like-Kind Exchanges?

There are a few rules your clients must follow to qualify for tax deferral under Section 1031.

Both the relinquished and replacement property must be held for investment or be used in a trade or business.

Exchanges of personal property cannot qualify for Section 1031 tax deferral.

The replacement property must be of like kind to the relinquished property.

Real property will be of like kind if it is of the same nature, character or class; the quality or grade does not matter. This means that farmland can be exchanged for a building, or an office building can be exchanged for a sect of rental houses. Additionally a single asset can be exchanged for multiple assets, and vice versa.

The replacement property must be of equal or greater value than the one sold.

If the replacement property is of lesser value than the asset sold, your clients may qualify for partial tax deferral, but they would be taxed on a portion of their gain.

Your clients must use an intermediary for a delayed like-kind exchange.

It is not feasible for taxpayers to perform simultaneous exchanges of real property, so almost all 1031 exchanges will be classified as delayed exchanges. In a delayed exchange, your client can sell their property before purchasing (or even identifying) replacement property, but they must use a qualified intermediary to facilitate the transaction.

A qualified intermediary will:

  1. Take ownership of your client’s relinquished property once it has been sold.
  2. Hold the relinquished property in trust until the replacement property is identified.
  3. Purchase the replacement property on behalf of your client.
  4. Transfer the rights to the replacement property to your client, and transfer the rights to the relinquished property to the purchaser.
Your client must identify potential replacement property within 45 days.

In a delayed exchange, your client has a few options when identifying potential replacement property (or properties). They must do one or more of the following:

  • Identify any three properties, regardless of value.
  • Identify an unlimited number of properties whose combined value does not exceed 200% of the relinquished property.
  • Identify an unlimited number of properties whose combined value exceeds 95% of the relinquished property.

In each instance, they can close on one or more of the identified properties when it’s time to finalize the purchase.

Your client must purchase the replacement property within 180 days.

The section 1031 exchange time limit is 180 days. This means that your client must close on one or more of the properties they identified within 180 days of the sale of their original property.

What Are the Benefits of Like-Kind Exchanges?

The tax deferral promised by Section 1031 is enough of a reason for most taxpayers to consider a like-kind exchange, but there are a few other benefits to pursuing one:

The tax deferral can free up cash to use in other areas of the business. The taxes that your clients aren’t paying today can be used to fund other business goals, like paying down debt, purchasing new property or expanding into new territories.

Diversification. Because most real property exchanges will qualify under Section 1031, your clients can use like-kind exchanges to diversify their investment portfolios. For example, if they are heavily invested in commercial real estate, they can diversify their investments by exchanging a commercial building for residential real estate.

Use equity to finance new property. Instead of using cash or taking out debt to finance a new asset purchase, they can use the equity they’ve built into their property to help them purchase a new asset.

Should Your Client Pursue a Like-Kind Exchange?

Today, like-kind exchanges are quite popular. The incentive has been around for so long that real estate investors understand the tax benefits, CPAs know how to report them and there are plenty of qualified intermediaries to help facilitate the transactions.

But this year and in the next few years, real estate investors have another opportunity they should consider: qualified opportunity zone (QOZ) investment.

Qualified opportunity zones allow taxpayers to defer capital gains if they invest cash or assets into economically depressed areas. Real estate investors can consider using QOZ investment as an alternative to like-kind exchanges or in conjunction with them. One benefit that QOZ investment has over Section 1031 exchanges is that QOZ investment can defer gains on sales of all capital assets, not just gains on real estate.

No matter what, make sure your clients know what their options are so they can make the most informed decision as they head into 2022.

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