Like Kind Exchange Accounting for 1031 Exchange Investments

August 17th, 2009

What’s a Like Kind Exchange

Like its name suggests, a “like-kind exchange” is a tax-free transaction where property is exchanged for other qualified property of the same type, hence the “like-kind” moniker. The property in question can be personal real estate or real estate that’s used in a trade or business or for investment. This type of exchange cannot be conducted with inventory, stocks, nor bonds. The exchange can be accomplished using the proceeds from a sale of land or development rights as long as the exchange property is identified within 45 days of the initial sale and the proceeds thereof are reinvested in qualified business or investment property within 180 days of such sale. Unless different property is received (called boot), the capital gains tax on the initial sale is deferred.

Accounting For Like Kind Exchanges

With a like-kind exchange, you use the proceeds of your sale to buy another piece of real estate of the same type. The appeal of such a transaction is that the IRS allows you to defer taxes on the gain until the replacement property sells. But then there’s nothing stopping you from doing the exact same thing (another like-kind exchange) in the future. What this means is that it’s possible for you to defer taxes indefinitely. It’s good to keep in mind, though, that if you don’t spend all the money that you get paid on the sale, the portion that you don’t spend will be considered by the IRS to be taxable income. Of course, such you should consult your tax advisor for guidance on the subject.

Like-kind exchanges free up more money to spend on new investments. For the sake of the example, let’s say you purchased a piece of real estate for $100,000 and it depreciates to $40,000. If you sell it for $80,000, you would normally have to pay ordinary income tax rates (probably 35%) on most or all of your $40,000 gain. But that’s where the like-kind exchange concept comes into play. Thanks to it, you’re allowed to apply all $80,000 to the price of more real estate, and not have to pay income taxes just yet. There’s even the possibility of doing a deferred exchange, meaning holding the money in a specific account (called a qualified exchange account) until you purchase the replacement property, using the money in the exchange account to pay for the purchase.

Once again, we want to stress that this post is a simplification of a complex process, subject to equally complex rules. You should consult with a tax professional before participating in such a transaction. The qualified intermediary cannot be your brother, your accountant, lawyer, or banker. You must use a disinterested third party—a qualified intermediary—or the IRS will not view it as a Safe Harbor transaction as the tax code requires.

You can also do a “reverse exchange,” in which replacement real estate is purchased before the previous property is sold. Reverse exchanges are subject to complicated rules and timetables, so professional guidance is again recommended.

1031 Exchange Investments

Hiring 1031 tax deferred exchange specialists and real estate consultants can help you achieve significant wealth through 1031 exchange investment vehicles. They can guide you through the process of buying and selling the properties so you can make money on your real estate investments. Thanks to their experience, they can advise you on ways to maximize your leverage, preserve your equity, increase your cash flow, consolidate or diversify, geographically relocate your investments, or convert the nature of your investments in order to gain relief from management.

1031 exchange investments offer the highest chance of completely deferring the payment of tax when the replacement property is of equal or greater value, and all the equity from the sold investment property is reinvested in the new investment property or properties. If you want to realize even higher profits, you can consider 1031 exchange investments with Tenants in Common (TIC) interest ownership in a property, also known as co-ownership of real estate. This option offers the benefit of allowing you to not only to defer your capital gains taxes, but also to upgrade your real estate investment into larger, institutional-grade properties.