What is a like-kind exchange?
Let us say that you acquired an asset and you disposed of another similar one. A transaction will allow you to do so without capital gains tax liability because you disposed of the other. We call this tax-deferred transaction a “like-kind” exchange.
Before, exchanges of different businesses are acceptable. You can also exchange one physical property for another. For instance, you can exchange heavy equipment with a vehicle. This is all possible until the passage of tax legislation in 2017. Afterward, like-kind exchanges are only available for businesses and real estate properties to another type of property. Are you still confused about it? We will explain more.
If an investor wants to sell a commercial or investment property for gain, he needs to pay capital gains tax on the generated profit. Why? There is a tax for every capital gain. It can be a capital gain at a shorter-term rate that falls at 10% to 37% for profits generated for selling a property in a year. It can also be a capital gain at a longer-term rate of 10% to 20% for profits generated after selling a property within the year of the purchase.
AKA 1031 Exchange
The like-kind exchange is also famous as Starker exchange or 1031 exchange. Internal Revenue Code’s or IRC’s Section 1031 states that an investor is exempted from making tax payments on gains if he will use the money earned from the disposal of an asset to buy a similar one. And when we say a similar one, the asset should be the same if its value is not equal or more significant. All real estates are like-kinds to any other real estate properties except for the personal residences. Hence, any real estate property for trade and productive business use is accepted as a like-kind exchange.
Taxes and like-kind exchanges
If you sell a property and buy another within the given time frame, you are exempted from paying taxes on the first sale or disposal. You can pay taxes as soon as the second property’s disposal is done. But if you decide to make another like-kind exchange, the tax payment will be deferred once more. Take note of these things when engaging with like-kind exchange so you can rest assured that there will be no tax liability upon selling the first asset:
- Asset on sale. Make sure that the asset being sold is not a personal residence but an investment property.
- Asset to be purchased. Before buying an asset, ensure that the asset you are buying from the proceeds should be similar to the asset on sale.
- Proceeds from the sale. The money you get from the sale should be used to buy another asset within 180 days after the first asset is sold. Furthermore, you should identify the asset you are buying in the like-kind exchange within 45 days of the sale.
Always double-check updates on tax rules before making like-kind exchanges. There are some capital gain amount limitations, and they can be tax-deferred. Always check for changes.
What else can like-kind exchange do?
The seller can defer their depreciation recapture. What is that? The gain one receives from selling depreciable capital property is to be reported as income. A like-kind exchange can help a taxpayer avoid these state taxes.