A like-kind exchange is a nontaxable exchange, which means a gain is not recognized and a loss cannot be deducted. This is an amazing way to roll a profitable real estate investment into the purchase of an alternate real property. The IRS under publication Publication 544 explains that the real property must be an investment and that the property must be the same in “nature or character.” This is regardless of grade or quality. The classic example is the exchange of an apartment house for a storefront or mixed-use building.
How is it done?
The 1031 Deferred Like-Kind Exchange can be tricky to implement. The investor has 45 days from the date the original property is relinquished to identify a property that is like-kind in “nature or character.” The identified property must be identified in a written statement that is signed by the investor and delivered to a person involved in the exchange of the replacement property, such as the seller of the targeted property or a qualified intermediary. Notice to the investor’s attorney, real estate agent, accountant, or similar persons acting as the investor’s agent will not qualify.
Once the replacement property is identified and written notice has been given to the agent (not acting on behalf of the investor), the completion of the transaction must take place within 180 days. Investors may not take receipt of the monies, and it is highly advisable that a third-party intermediary handle the transaction so that the proceeds from the relinquished property are directly invested into the replacement property. A qualified intermediary will report the Like-Kind Exchange on Form 8824 to file with the investor’s tax return for the year in which the transaction took place.
Advantages of Like-Kind Exchange
A prudent real estate investor who has been fortunate enough to hold property with significant gains should increase the return by rolling the gains into a more profitable property or a more stable property in a better location. A good example is an investor who has purchased an apartment building in an area that has undergone a renaissance where vacancy rates were once high and are now substantially lower. An investor can take the gains from the real property investment and purchase a larger apartment building in the same area, while keeping the mortgage lower or about the same. This will allow an investor to earn more rent from a larger complex.
Disadvantages of Like-Kind Exchange
There are disadvantages to like-kind exchanges; for one, they are complicated, and an intermediary will charge a fee to execute the exchange. If the transaction is not handled properly, the gains will be realized and taxes will be assessed on the proceeds from the sale of the relinquished property. In areas where real estate transactions close quickly, it may not be possible to execute a like-kind exchange. These transactions can take time and in a seller’s market, the buyer will be at a disadvantage purchasing the identified property. If the transaction is not completed in time and the identified property is not purchased in the designated time frame, a tax consequence will be assessed in that fiscal year.
The benefits exceed the risks outlined under the disadvantages. An investor should carefully research an intermediary with years of experience in like-kind exchanges. Ask for references from both the intermediary’s clients and commercial real estate brokers who have worked with them. You will quickly find how knowledgeable the intermediary is and how successful he or she has been in executing these transactions.