Like Kind Exchanges

Business Tax

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NEWSLETTER
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May, 2004
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If you plan to dispose of some business or investment property that has appreciated value in the near future, you may want to consider the opportunity to "postpone" the tax on your capital gain by exchanging it for "like-kind" property.

Sound intriguing?  Exchanging like-kind property in order to postpone tax is a concept that has been used many times in the past, but with a little forethought and creativity, it could probably be utilized much more than it is. Basically, the tax law allows you to defer a taxable gain on business or investment property that you dispose of if you also acquire property for the same or more than the selling price of the property disposed of.  One example where the like-kind exchange rules are used quite extensively is with business vehicles.  

If your business purchased a delivery truck in 1980 and continually traded it in for a new one every two years since that time, chances are you have never paid a dime in taxes on the gains that have been deferred.  Of course, when your business finally disposes of the delivery truck without trading for a new one, all of those deferred gains will be taxed.  

It is also possible that you could be deferring losses instead of gains each time you trade since vehicles tend to lose value very quickly.  It pays to keep a close watch on your property's depreciable and market values when you are considering a trade.

The exchange of properties does not have to be simultaneous. However, the replacement property must be identified within 45 days of transferring title to the property.  In addition, you must receive the replacement property within 180 days of the original transfer.  You are also not required to swap properties with only one entity.  For example, you want to swap your office building for an office building on X Street that is for sale.  

However, the owner of the X Street building doesn't want your building, but will swap for an apartment building.  If you can find an owner of an apartment building willing to swap for your office building, the like-kind exchange rules will allow you to do a 3-way (or more) swap so that all parties get the property they want and postpone taxes on their capital gains.

FOLLOWING THE RULES

The rules for like-kind exchanges can vary depending upon the type of property involved.  The rules aren't too stringent in the case of real estate.  For example, undeveloped land held for business or investment can be exchanged for land with a building, rental property, farm property or even a partial interest in other real estate.  However, the rules are not quite so lax in regard to non-real estate.  

Depreciable tangible personal property must pass a "like class" test. The classes are based on 13 IRS general asset classes and product classes consisting of 4-digit Product Classes within Division D of the Standard Industrial Classification (SIC) Codes.

The most common asset classes are as follows:

  • office furniture, fixtures, safes, etc.
  • information systems (computers and peripheral equipment)
  • automobiles and taxis
  • buses
  • light general purpose trucks
  • heavy general purpose trucks
  • tractor units for use over-the-road
  • trailers and trailer-mounted containers

So long as you stay within the asset class, you should be safe.  For instance, exchanging an old office desk for a new credenza should qualify for like-kind treatment.  However, you would not be able to defer your gain if you traded a business auto for a light delivery truck.  

If you are considering making an exchange of property in anticipation of using the like-kind rules, you may want to consider calling our office for further guidance on the rules.

BUSINESS OR INVESTMENT PROPERTY

Please keep in mind that the like-kind exchange rules only apply to business and investment property. Exchanging a vacation home on the west coast for one in Florida will not qualify for like-kind treatment.  Property held for productive use in a trade or business includes machinery, office equipment, furniture and fixtures, real estate, etc.  

Property held by a business for resale (such as inventory) does not qualify for like-kind treatment.  If your company produces widgets, you could not trade 1,000 of your blue widgets for 500 green ones under the like-kind exchange rules.  Likewise, a real estate developer could run afoul of the like-kind exchange rules if he or she exchanges real property and the IRS determines that the property was being held for resale instead of investment. 

PARTIAL GAINS

The receipt of cash will almost always trigger a capital gain unless you use an intermediary or a qualified escrow account to hold the cash until it is reinvested in like-kind property within the 180 day replacement period.  If you actually receive a check after a sale, it disqualifies your like-kind exchange even if you don't cash it.  

Under the like-kind exchange rules, you cannot receive, pledge, borrow or otherwise obtain the benefits of the money before the end of the replacement period.

Likewise, the receipt of any cash during a bona fide like-kind exchange will trigger a taxable gain.  For example, you purchased land for $50,000 and held it for several years before exchanging it for land worth $100,000 and $20,000 in cash.  Your total gain on the transaction is obviously $70,000 ($120,000 received less the $50,000 you originally paid for your land), but you will only recognize $20,000 in gain for the amount of cash you received.

The result of the above example would be the same if, instead of receiving $20,000 in cash, you received a bulldozer valued at $20,000.  Since the bulldozer, like the cash, would not qualify as like-kind property with your land, it triggers immediate recognition of the capital gain.

NEW PROPERTY BASIS

Your basis in the new property will be the amount of your basis in the old property plus the amount of gain recognized or any unlike property given up in the transaction. Using our example above where you traded your land, your basis in the new land would be $70,000 (even though the market value is obviously $120,000).  

We arrive at this by taking your basis in the old property (the $50,000 you gave for the land several years ago) and adding to it the $20,000 gain that you were forced to recognize on the transaction.  Thus, if you later sell your newly-acquired land for $150,000, your gain would be $80,000 ($150,000 sale price less your $70,000 basis).

Like-kind exchanges can save you a tremendous amount in taxes, but they require careful planning and a long-term view of your objectives for the new property.  As we stated above, please give us a call if you are considering a like-kind transaction.  We can assist you in examining the potential transaction and exploring any creative alternatives you may wish to consider.

 

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This Information Is Not Intended For Use Without Professional Advice
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