Even with the current downturn in the real estate market, like-kind exchanges continue to be a popular way to dispose of property while deferring the taxable gain.
An example of a like-kind exchange is the exchange of an apartment building for an office building. An exchange of like-kind property will receive nontaxable treatment if the exchanging party satisfies the following conditions:
· The transaction is, in fact, an "exchange" (not a sale);
· The property transferred and the property received are held for productive use in a trade or business or for investment; and
· The properties are qualifying and of like-kind.
If a like-kind exchange is used to defer tax, it is important to meet the technical requirements of Section 1031 of the Tax Code. Otherwise, the exchanging parties would have a tax liability, but no sales proceeds with which to pay the tax.
Only certain types of property qualify for tax-free exchange treatment. Some assets such as stocks, bonds, notes and partnership interests do not qualify, regardless whether the underlying properties are of like-kind. Since the property must be held for use in a trade or business or held for investment, inventory and property held for sale to customers do not qualify.
The words "like-kind" refer to the nature or character of the property, not to its grade or quality. It doesn't matter if the real property is improved or unimproved since that designation relates only to the grade or quality of the property and not to its character. In fact, the regulations specifically state that improved real estate may be exchanged for unimproved real estate.
Although the categories of real property that may be exchanged are broad, dealer property will not qualify under any circumstances.
If additional property (not of like-kind) is given or received in a like-kind exchange, then gain may be recognized. Non-qualifying property is termed "boot." In general, gain realized on the exchange is recognized to the extent of the fair market value of boot received.
If an exchange qualifies for like-kind treatment, the basis of the property received is not increased by any deferred gain. In general, the tax basis of like-kind property received is the same as that of the property exchanged, decreased by the amount of any money received, and increased by any gain (or decreased by any loss) recognized on the exchange.
Typically, gains from the sale of improved rental real estate offset passive losses. If you have excessive current and suspended passive losses, you may be better off selling your property and recognizing taxable gains to offset your unused passive losses. Not only will this allow you to get a current benefit out of your suspended losses, but you will receive a higher tax basis in any new property you acquire with the sale proceeds.
If you are planning an exchange with a related party, the exchange may become taxable. Gain is triggered if the related party disposes of the exchanged property within two years.
An exchange is appropriate if you are only trying to upgrade your real estate holdings without the need for cash. However, if you are trying to liquidate properties in order to generate cash, then an exchange would obviously not accomplish your goal.
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