Most like-kind exchanges of real estate are not simultaneous, so they are referred to as a deferred like-kind exchange. These exchanges have special rules in place that must be followed in order for the exchange to be considered “like-kind” and meet certain safe harbor rules of the IRS.
First, the properties you are exchanging must be considered like-kind. A like-kind exchange is any exchange (1) of real property held for investment or for productive use in your trade or business (relinquished property) for (2) like-kind investment real property or trade or business real property (replacement property). For these purposes, “like-kind” is very broadly defined and most real property is considered to be like-kind with other real property. However, neither the relinquished property nor the replacement property can be real property held primarily for sale.
You should be aware that, beginning in 2018, new tax legislation has limited like-kind exchanges to only real property such as land and buildings.
Assuming the properties qualify, here’s how the taxes work.
If you exchange the two properties and they are exactly equal in value, then there is no gain on the transaction. For example, you exchange a rental property worth $400,000 for another rental property worth $400,000, there is no gain recognized for tax purposes. Remember, however, that the gain is only deferred until the time you sell the new property. This is not a permanent forgiveness of tax. You are only deferring the tax bill to a future year.
If the properties are not equal in value and you receive cash or other non-like-kind property (otherwise known as “boot”) to make up the difference, you will have some taxable income equal to the amount of cash or other property you receive.
If the property you are exchanging is subject to debt from which you are being relieved, the amount of the debt is treated as boot. The theory is that if someone takes over your debt, it’s equivalent to you receiving cash. Of course, if the replacement property is also subject to debt, then you are only treated as receiving boot to the extent of your “net debt relief” (the amount by which the debt you become free of exceeds the debt you pick up).
Now, back to the “deferred” like-kind exchange.
To qualify under the deferred like-kind exchange rules, the following time limits must be met:
- The new, replacement property must be “identified” no later than the day that is 45 days after the transfer/sale of the old, relinquished property. Identification must be made in writing and clearly describe in appropriate detail the property to be transferred. It’s possible to identify up to three alternative replacement properties (or any number of properties as long as their aggregate fair market value doesn’t exceed 200% of the aggregate fair market value of all the relinquished properties).
- The actual transfer of the new replacement property must occur no later than the earlier of:
- the day 180 days after the transfer of the relinquished property, or
- the due date (including extensions) of your tax return for the year in which you gave up the relinquished property in the exchange.
You should be particularly careful with this second requirement. If you transfer the relinquished property late in the tax year, you should not automatically assume that you have 180 days to receive the replacement property. Say you transfer your property on December 10th. If you don’t get an extension for filing your tax return, you will have to receive the replacement property in exchange by April 15th, which is earlier than the day which is 180 days after December 10th. Of course, in this case, a filing extension will give you additional time.
There may be some ways for creative, alternative arrangement to allow additional time to make things work. These include temporarily leasing the property or having an option to buy one of the properties that gets exercised when enough time is allowed to make the transaction work within the prescribed rules.
