Like-Kind Property Exchanges Can Be Tricky
One provision of the Tax Cuts and Jobs Act that was passed in December 2017 that taxpayers need to be aware of is that like-kind exchanges are now generally limited to exchanges of real property. Prior to Jan. 1, 2018, tax-deferred exchanges could be done when trading in equipment, vehicles or other business property. Commonly it was used when trading in a vehicle.
Here is an example. Let’s assume that I purchased a vehicle for $50,000 several years ago, used it 100% for business and that I have fully depreciated the vehicle on my books. My value of the vehicle is now zero. Then, I decide to trade that vehicle in and, when I do, the dealer gives me $10,000 for my old vehicle to put toward the purchase price of my new $40,000 vehicle. Therefore, I will have to pay the dealer $30,000 (not taking into account taxes, title and other fees).
The gain on this transaction is $10,000. The old law allowed a like-kind exchange of this asset by reducing the new vehicle’s cost on my books to $30,000. With the new law, the vehicle must be put on the books for $40,000 and a gain of $10,000 must be recognized.
Many times, the depreciation allowed in year one does not outweigh the taxable gain and, as a result, the company’s taxable income is increased.
Section 1031, like-kind exchange, continues to apply to real property that is held for use in a trade or business or investment (not principal residence). Real property, also called real estate, includes land and generally anything built on or attached to it.
Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. Improved real property is generally of like-kind to unimproved real property.
For example, an apartment building would generally be of like-kind to unimproved land. However, real property in the United States is not of like-kind to real property outside the country.
There are many rules that must be followed for a like-kind exchange to be legal. For instance, after selling a property, the funds from the sale must be held by a qualified intermediary.
The replacement property must be identified within 45 days and acquired within 180 days from when the original property was transferred. Failure to follow the laws will result in the exchange not qualifying for tax-deferred treatment and could result in a hefty tax bill.
Like-kind exchanges are complex. If you are considering doing one, be sure to consult with a certified public accountant and an attorney who regularly closes like-kind exchanges prior to the sale. Otherwise, you may be in for an unwelcome surprise.