Like-kind exchange can defer taxes

Q:

A couple of weeks ago, you wrote that you have to pay capital gains taxes on the sale of a rental property.

I thought there was a way to avoid capital gains taxes by rolling over the gain into another rental or some other investment property. Can you no longer do this?

A:

Yes, you can. Under Section 1031 of the Internal Revenue Service code, it is possible to defer the tax on gain on commercial properties through a “like kind” exchange.

“Like kind” property is defined as property that is held for investment or for productive use in trade or business (not including inventory or other property held primarily for sale).

The property being sold and the property being bought in replacement must both be commercial properties, but they do not need to be of identical use or of the same value.

For example, one could exchange a residential rental property for another rental property, or for a commercial office building, a strip mall, a piece of farm land or any other commercial-use property. The properties could be located in different states.

In order to do an exchange and qualify for a tax deferral under Section 1031, the taxpayer must follow certain procedures within a very short time frame. The window for completing a like-kind exchange is only a matter of days so the properties one is selling and then buying need to be all lined up.

Additionally, the transactions have to be handled by a qualified facilitator, usually an attorney with experience in this area or a title insurance company. All the money passes through the facilitator.

Like-kind exchanges of commercial properties are not that common, but experts say this is not because they are particularly hard or complicated to carry out, but rather because people just don't know about them.     

The biggest hurdle to completing a like-kind exchange is lining up all the people involved. You need four people: yourself with a property to sell; a buyer for your property; a seller with a property you want to buy, and a qualified facilitator.

You don't need to have the permission of the other parties in order to do a tax-free exchange. From their point of view, it’s exactly like any other closing.

If you have any debt on your property or other unusual situation, a like-kind exchange can get more complicated. Hiring a qualified facilitator to do the exchange can also be expensive.

But the potential tax savings from the deferral of gain can often far outweigh these expenses, especially for individuals who have held rental property for many years and have little or no tax basis due to depreciation taken.

In this type of situation you could be faced with a huge tax bill on the sale proceeds. A like kind exchange enables you to roll over that gain into another property.