Small Business Taxes & ManagementTM--Copyright 2013-2014, A/N Group, Inc.
Most taxpayers have heard about a like-kind exchange. It's a way of avoiding the current recognition of gain on the disposal of an asset. In the simplest terms, it's trading one asset for another without receiving any cash on the transaction. But, as always, the transactions and rules can be more complicated. And any gain on the disposal of the asset is deferred to when it's ultimately sold. Not all like-kind exchanges qualify for deferral treatment. Only property used in a trade or business or held for investment qualifies, and some property (e.g., stocks), are excluded.
Example--Fred owes 10 acres of farmland five miles from his dairy farm. He purchased the land some 25 years ago for $5,000. Five years ago he was offered $100,000 for the property, but he exchanged it for 20 acres for nearby land along with an additional payment of $85,000. There was no current tax effect, and the new 20 acres had a basis of $90,000 ($5,000 original basis plus $85,000 cash paid in the exchange). Fred avoided tax on a $95,000 ($100,000 offered less $5,000 basis) gain. But Fred now has an offer for the property from a developer for $375,000. If he sells the property he'll have a gain of $280,000 ($375,000 less $90,000).The receipt of any amount of unlike property can trigger recognition of gain. For example, Fred trades his truck with a value of $5,000 to Sue for her truck with a value of $4,500. To make up the difference, Sue throws in her laptop computer. Fred may have to report a gain or loss on the exchange. More commonly it's money that's used to equalize the transaction, but the outcome is the same.
While it sounds like it makes sense to always do a like-kind exchange, that's not necessarily true. There are times when taking the gain can be the smarter move.
We'll start out with the basics and deal with the exceptions and fine points later. There's a good chance you'll never have to deal with those fine points.
Qualifying Property This is the first requirement. Both the property you're giving up and the property you receive must be held for investment or productive use in a trade or business. Vehicles, machinery, etc. used in a business qualify. Rental property may also qualify.
Certain property doesn't qualify including:
A vacation home may qualify if it is owned for at least two years at the time of the exchange and rented for a requisite period of time; the same is true for the replacement property.
A dwelling unit qualifies as relinquished property if it is owned for at least 24 months immediately before the exchange and in each of the 12-month periods immediately prior to the exchange the property is rented to another person or persons at a fair rental for 14 days or more, and the period of the your person use of the property does not exceed the greater of 14 days or 10 percent of the number of days during the 12 month period that the dwelling unit is rented at a fair rental. The same requirements must be met for the replacement property.
Caution. Don't guess on what a fair rental would be. Get advice from a real estate professional. Failing to do so could be costly.
What about an exchange of one business for another? Only the exchange of the individual assets qualifies. For example, Madison's building for Chatham's building; Madison's office furniture for Chatham's office furniture, etc.
Like-Kind Property The second basic requirement is that the property exchanged must be like kind. For example, a truck for a truck. In the case of real estate, the most common type of like-kind exchange, almost any ownership interest in real property for another interest in real property qualifies. For example, exchanging raw land in a rural area for a rental apartment in the city qualifies. Some exchanges don't qualify. For example, the exchange of a life estate expected to last less than 30 years for a remainder interest is not a like-kind exchange.
Caution. Real property located in the U.S. and real property located in a foreign country are not like-kind properties.
Even if you exchange real property for real property you can inadvertently have a exchange of unlike properties. For example, Fred transfers raw land for a rental property on the lake. The rental property is furnished. The furniture doesn't qualify as like-kind property. The tractor in the garage used to plow snow in the winter is also unlike property. There could be several options here. Consider a separate transaction for the personal property if you want to avoid the problem. Detail the property involved and take pictures, particularly if you believe the value is insignificant. Talk to your tax advisor.
When it comes to personal property (vehicles, furniture, machinery, etc.) what constitutes like-kind property gets far more complicated. Depreciable tangible personal property can be either like-kind or like-class to qualify. Like-class is that is described in a General Asset Class or in a product class.
General Asset Classes include the following property:
Product classes include property listed in a 6-digit product class (except any ending in 9) in sectors 31 through 33 of the North American Industry Classification System (NAICS). You can find the manual online at www.census.gov/naics. The requirements under this category are much more restrictive than under the general asset classes.
Example 1--Madison Inc. exchanges three file cabinets and two chairs for six desks for your business. Since all the property is in the same General Asset Class, all the items qualify for like-kind treatment.
Example 2--Madison Inc. trades in two autos for a new pickup truck and $21,000 in cash. The transaction does not qualify as a like-kind exchange because autos and trucks are in two different General Asset Classes.
Example 3--Madison Inc. exchanges a bulldozer for a crane. Neither property is in a General Asset Class, but properties are in the same Product ClassIntangible property, such as copyrights, may be like-kind property. Goodwill and going concern value for similar property of another business is not like-kind property. In order to be like-kind property, the property must be used predominately in the U.S. The testing period includes the 2-year period before the exchange date for the property relinquished and 2 years after the exchange date for the property acquired.
Co-Ownership of Property An exchange of property by co-owners can qualify for a like-kind exchange, but the relationship must meet certain requirements. The co-owners must hold title to the property must be held as tenants-in-common, there can be no more than 35 co-owners, and the co-owners can't be organized, operate as a business, or conduct business under a common name, and co-owners must have the right to transfer and encumber their undivided interest without approval of any person. There are other requirements. For more information, see Rev. Proc. 2002-22.
There's a strong possibility you won't be lucky enough to find a party to do an exchange with. That's particularly true in the case of real estate. You could engage in a multiple party exchange involving three or more properties. Often there's an easier way, using a qualified exchange intermediary and a deferred exchange.
A deferred exchange is an exchange in which you transfer qualifying property and later receive replacement property. But you can't receive payment for the property you're relinquishing--that makes the transaction taxable. Instead, you can have an intermediary hold the proceeds from the sale of the relinquished property and use that amount to purchase the replacement property. We'll discuss the mechanics later. You must be careful not to actually or constructively receive any money or unlike property if you want to avoid a partially taxable transaction.
In a deferred exchange you must identify the property to be received within 45 days after the date you transfer the property given up in the exchange (the identification period). Any property received during the identification period is considered to be identified. If you transfer multiple properties at different times, the identification period begins on the date of the earliest transfer.
You must identify the replacement property in a signed written document and deliver it to the person obligated to transfer the replacement property or any other person involved in the exchange except a disqualified person. You must clearly identify the replacement property--for real property the legal description or street address. For other property, the best description you can. For example, in the case of a vehicle, the make, model, and year.
You can identify up to three replacement properties without regard to the value of the properties. You can identify more than three replacement properties, but the total fair market value at the end of the identification period can not more than double the total fair market value, on the date of transfer, of all the properties you relinquish (200 percent rule). You can revoke an identification of replacement property if you do so before the end of the 45-day identification period.
Replacement property that has yet to be produced (e.g., a building under construction) can qualify. But the 180-day rule applies. That is, you must close on the property by that time. And only the completed value of the property can be used as replacement property.
You can disregard incidental property if it's typically transferred with the larger property and the total value of all incidental property doesn't exceed 15% of the total fair market value of the larger item of property. For example, appliances transferred with a rental property. To avoid a challenge with the IRS you might want to get an appraisal of the incidental property (if there's no "blue book" value available) or consider a separate bill of sale. The replacement property must be received by the earlier of the following:
This period is called the exchange period. You must receive substantially the same property that met the identification requirement. The exchange period starts on the day of transfer of the relinquished property. If you relinquish more than one property, the exchange period starts on the day the first property is relinquished.
CAUTION. The 45- and 180-day deadlines are absolute. Extensions have been granted in the case of a presidentially declared natural disaster (see Notice 2005-5).
Deferred Exchange Mechanics
Generally, you'll need a qualified intermediary. The intermediary acquires title to the property you give up, transfers the property you give up, acquires the replacement property, and transfers the replacement property to you. In order to come within the protection of the safe harbors against actual and constructive receipt of money and unlike property, the agreement must provide that you have no rights to receive, pledge, borrow, or otherwise obtain the benefits of money or unlike property before the end of the exchange period. The intermediary must not be a disqualified person. That person can't be your agent at the time of the transaction, a person who is related to you (check the definition), a person who is related to a person who is your agent at the time of the transaction. For example, your lawyer, CPA, real estate agent, etc. is a disqualified person. Anyone who has acted as your agent within the last two years is also disqualified.
The simplest way to avoid an issue here is to find a professional qualified intermediary who specializes in such transactions. Your banker, real estate broker, CPA, or attorney should be able to provide the name of a reputable intermediary. Intermediaries know the mechanics of the transaction and the cost is usually small. If you decide to use a person other than a qualified intermediary you'll have to make sure you the escrow account qualifies and you meet the requirements for a qualified transfer. Because there's such a risk of making a fatal error and the consequences are so high, using a professional intermediary makes the most sense.
Qualified Exchange Accommodation Arrangements
Can you acquire the replacement (new) property before you transfer the relinquished property? While technically not a like-kind exchange, gain can be deferred if you use a Qualified Exchange Accommodation Arrangement (QEAD). Such an exchange is called a "reverse Starker" transaction after a 1979 court case. Basically, the arrangement is the reverse of a like-kind exchange. Under a QEAD either the replacement property or the relinquished property is transferred to an exchange accommodation titleholder (EAT) who is treated as the owner of the property. However, for transfers of qualified indications of ownership, the replacement property held in a QEAD may not be treated as property received in an exchange if you previously owned it within 180 days of its transfer to the EAT.
No later than 45 days after the transfer of qualified indications of ownership of the replacement property to the EAT you must identify the relinquished property in the same was as you would in a like-kind exchange and within 180 days after the transfer of qualified indications of ownership if the property to the EAT the relinquished property is transferred to a person other than you or a disqualified person. The combined time period the relinquished property and replacement property are held in the QEAD cannot exceed 180 days.
Example--Fred finds that 10 acres adjacent to his farm has just gone on the market at an attractive price. He owns several woodlots that have been logged with a low basis and wants to do an exchange. While only a woodlot would be transferred in the exchange, finding a buyer for a woodlot won't be easy. He finds an EAT who acquires the 10 acres. Within the 45 days he identifies two woodlots as the relinquished property and within 180 days of the acquisition of the 10 acres by the QEAA, the QEAA acquires and transfers to the ultimate purchaser one of the identified woodlots.The rules are more complex, but, many of the requirements are the same as those for a regular like-kind exchange.
This is probably one of the most common types of like-kind exchanges. The same rules apply, but the time restraints are rarely an issue. For example, Madison Inc. goes to the local dealer to replace a truck. You're unlikely to relinquish your truck only to wait more than 180 days for a new one. But the rules remain the same so you should be aware of them when entering into a transaction for vehicles or equipment.
There's a twist here. On a vehicle or equipment trade-in you're more likely to have a loss on the property than in the case of real estate. Or you may want to have a higher basis in the property (explained below). Or recognize gain on the sale for any number of reasons. If that's the case you may to avoid a like-kind exchange. That can be difficult if the sale of the old property and the purchase of the new one are reciprocal and mutually dependent. For example, Madison Inc. sales a used bulldozer to the dealer and purchases a new one a week later. The transaction may be treated by the IRS as a like-kind exchange. Unless you're doing a private sale and purchasing the new equipment from an unrelated dealer, discuss the transaction with your tax advisor.
Exchanges of Like and Unlike Property
It gets a little trickier if you exchange cash, unlike property (often referred to as "boot", although no one is quite sure of the origin of that term), or there's an assumption of liabilities by one or both of the parties. You could recognize gain or loss on the transaction. And you may have to adjust your basis for future gain or loss or depreciation purposes. The issue is easier to deal with using examples. We'll avoid depreciable property such as buildings, equipment, etc. as much as possible since that further complicates the issue.
Example 1--Fred exchanges 10 acres of woodlot which cost him $10,000 (it's now worth $22,000) some years ago for 3 acres of farmland owned by Sue for which she paid $17,000 two years ago. There is no money, boot, or expenses involved. There's no gain or loss to either party and Fred's basis in the farmland is $10,000, Sue's basis in the woodlot she acquired is $17,000.
Example 2--The facts are the same as in Example 1, but Fred has to pay $4,500 in addition to the 10 acres. Fred's basis in the farmland is $14,500 ($10,000 original basis plus $4,500 for the cash given up). Fred has no gain or loss. But Sue has received $4,500 in cash. The fair market value of the property she received was $22,000 added to the cash of $4,500 she received a total of $26,500. Her basis (cost) in the farmland was $17,000 so she has a gain of $9,500 $26,500 less $17,000). Although she realized a gain of $9,500, she only has to recognize (i.e., is taxable on) $4,500, the amount of unlike property (in this case cash) she received. Sue's basis in the woodlot is equal to her original cost of the farmland, $17,000, plus the amount of gain ($4,500) she recognizes on the transaction, or $21,500.
Example 3--The facts are the same as in Example 2, except instead of giving Sue $4,500 in cash Fred assumes Sue's $4,500 mortgage on the farmland. The result for both parties is the same as if cash was transferred.If Fred assumes some of Sue's liabilities on the property and Sue assumes some of Fred's, the assumed liabilities offset each other. The transfer of cash and liabilities is also offsetting. For example, you can decrease (but not below zero) the amount of money you are treated as receiving by the amount of the other party's liabilities you assume and by any cash you pay or unlike property you give up.
If, in addition to like-kind property, you give up unlike property, you must recognize gain or loss on the unlike property you give up. The gain or loss is equal to the difference between the fair market value of the unlike property and the adjusted basis of the unlike property.
Example 4--Fred exchanges farmland with a fair market value of $38,000 and an adjusted basis of $30,000 and a truck with a fair market value of $2,000 and an adjusted basis of $8,000 for farmland with a fair market value of $40,000. Fred doesn't recognize (report on his tax return) a gain on the exchange of the real estate, but must recognize a $6,000 loss on the truck because it's unlike property.
Example 5--The facts are the same as in Example 4, but the adjusted basis of the truck is only $500. Fred has to recognize a gain of $1,500 on the transfer of the truck.
Basis of Property Received
The total basis for all properties (other than money) you receive in a partially nontaxable exchange is the total adjusted basis of the properties you give up, with the following adjustments. Add:
Allocate this basis first to the unlike property, other than money, up to its fair market value on the date of the exchange. The remainder is the basis of the like-kind property.
Example 6--The facts are the same as in Example 5. Fred's basis in the farmland is $39,500, his adjusted basis in the farmland given up ($38,000) plus the $1,500 gain recognized on disposition of the truck.
Generally, in a like-kind exchange the carryover basis of the replacement property is depreciated using the same life and convention, and over the same remaining period as the relinquished property. Any additional basis is depreciated using the appropriate life and convention that would apply to the new property. For example, Fred exchanges an old tractor for a newer one and gives Sue and additional $5,000. Fred's adjusted basis (cost less accumulated depreciation) in the old tractor was $20,000 and the remaining life was 3 years. Fred continues the same depreciation on his $20,000 of basis in the replacement tractor. On the additional $5,000 in basis, Fred will begin depreciation using the 7-year life applicable to the tractor. Thus, the tractor will have two separate depreciation schedules. Fred could also take the Section 179 election on the $5,000 in new basis.
That's the general rule. But things can get a lot trickier. Special rules apply if the lives of the relinquished and replacement properties are different. That occurs most frequently when there's an exchange of real estate where a commercial property (life of 39 years) is exchanged for a residential property (life of 27.5 years).
Special rules apply where there's a deferred exchange. Basically, no depreciation is allowed for the time after the disposition of the relinquished property and before the acquisition of the replacement property. Special rules also apply to autos and trucks subject to the depreciation limitations.
Revenue Procedure 2008-16 provides a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment purposes. In order to qualify as a like-kind exchange, both the relinquished and replacement property must meet certain criteria.
The relinquished property qualifies if:
The first 12-month period immediately preceding the exchange ends on the day before the exchange takes place and the second 12-month period ends on the day before the first 12-month period begins.
The replacement property qualifies if:
The first 12-month period begins on the day following the exchange and the second 12-month period begins on the day after the first 12-month period ends.
This is a safe harbor. You may be able to convince the IRS or a court that the transaction qualified as a like-kind exchange even if you don't pass this test. For example, you easily meet the test during the first 12-month period (you rent the property for three months during the summer season and don't use the property at all during the year), but fail the test during the second 12-month period despite your efforts to rent the property. Talk to your tax advisor.
Exchange Expenses. Exchange expenses generally consist of closing costs such as brokerage commissions, attorney fees, deed preparation, etc. Subtract these expenses from the consideration received to figure the amount realized on the exchange. You should also add them to the basis of the like-kind property received. If you receive cash or unlike property, subtract the expenses from the cash received or the fair market value of the unlike property received.
Partial Business or Investment Use. You may trade in a vehicle or other property that's partly for business and partly for personal purposes. Only the business portion of the property qualifies for a like-kind exchange.
Multiple Properties. If you trade multiple properties at one time you generally must make a property-by-property comparison to determine your recognized gain and the basis of the property you receive in the exchange. You can find out more about multiple property exchanges in IRS Publication 544, Sale and Other Dispositions of Assets.
Intangibles. It is possible to do a like-kind exchange of intangibles, but what constitutes like-kind property is less clearly defined. Whether the property is like-kind depends on the nature or character of the rights involved (e.g., copyright, patent, etc.) and on the nature or character of the underlying property to which those rights relate. For example, the exchange of a copyright on a film for a copyright on a film should be a like-kind exchange. The exchange of a copyright on a film for a copyright on a novel would not be.
Recordkeeping. No discussion about taxes would be complete without a mention of recordkeeping. Here, the issue is that your basis in the property is a carryover basis. That means, you could be required to support the basis in the original property. For example, in 1969 Fred, fresh out of college, bought the house he lived in during his senior year for $9,000. He rented the property for six years and exchanged it, along with $5,000 cash, for two properties. Some 10 years later he exchanged one of those properties for a small office building. He held that for 15 years and exchanged it for a small strip mall. Ten years later he exchanged the strip mall for another office building. Two years later he sold the office building. He reported the gain on his tax return but was audited. The IRS challenged his basis in the office building. Because his basis was determined, in part, by the price he paid for the house he bought in 1969, he had to substantiate what he paid for that property. (Costs related to the additional exchanges, the exchange of one property for two and one point, and unlike property paid or received over the years had to be documented also.)
Other Nontaxable Exchanges. While not like-kind exchanges, there are several other transactions that are nontaxable:
Related Parties. While you can do a like-kind exchange with a related party, special rules apply and affect both direct and indirect exchanges. If either party disposes of the property within 2 years after the exchange, the exchange is disqualified from nonrecognition treatment. The gain or loss on the original exchange must be recognized as of the date of the later disposition. Dispositions due to the death of either related person is an exception, as is involuntary conversions.
Related persons include you and a member of your family, (spouse, brother, sister, parent, child, etc., you and a corporation in which you have more than 50% ownership, you and a partnership in which you directly or indirectly own more than a 50% interest of the capital or profits, and two partnerships in which you directly or indirectly own more than 50% of the capital interests or profits.
Timing. A like-kind exchange only defers the tax bill, it generally doesn't eliminate tax on the gain. The only time it eliminates gain if you're holding the property when you die. In that case your heirs will get a new basis in the property, totally avoiding gain. But you can substantially reduce the tax bite by proper timing.
Example 1--Sue has a rental property in another state that has become a headache to manage. Because of a large capital gain on the sale of some stock she'd pay the top capital gain rate and the 3.8% net investment income tax if she sold the property. It's unlikely the large capital gain will recur and she'll be in a lower bracket for a number of years. Doing a like-kind exchange makes sense.
Example 2--Fred has substantial capital loss carryforwards but has a rental property with a large gain. While the losses can be carried forward, but if he sells the property now he'll avoid tax on the gain and secure a new, higher basis in a new property.The decision becomes more important with personal property (e.g., a business truck). Chances are any gain will be small, but most of it will be depreciation recapture which is taxed at ordinary income rates. But depreciation on the new property is more rapid and you may be able to expense the entire cost in the year of acquisition.
Example--Fred wants to replace a tractor. It's December and he's had a bad year. If he exchanges the tractor he'll avoid tax on $35,000 of depreciation recapture, but he's in the 10% bracket this year. He'll be in a much higher bracket next year. If he sells the tractor he'll pay tax this year, but if he buys the new tractor next year he'll have a much larger Section 179 expense deduction.Keep in mind that a like-kind exchange not only defers gain, it also defers loss. If, instead of electing to expense the property you depreciated it, you could easily have a loss. Sit with your tax advisor and run through the numbers.
If the property you're disposing of is a real estate rental and you have accumulated carryforward passive losses, either from that or other properties, you should analyze the situation carefully. If, instead of doing a like-kind exchange you sell the property you might be able to utilize the carryforward passive activity losses. Another point for discussion with your advisor.
Copyright 2013-2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 01/29/14