In most cases when you dispose of a capital asset that has appreciated in value you will have to recognize gain on the sale of that asset.  You may be able to avoid recognizing gain if instead of selling the asset you exchange or replace it with a similar asset.  This is accomplished through a Like-Kind Exchange also called a 1031 Exchange.

Internal Revenue Code Section 1031 (the code section that deals with Like-Kind Exchanges) states:

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

The law excludes exchanges of inventory, stock, bonds and interests in partnerships from the non-recognition of gain in a 1031 or Like-Kind Exchange. Each year, there has been more scrutiny on Like-Kind Exchanges by the Internal Revenue Service, resulting in more court cases.

One area of the Like-Kind Exchange rules that the Internal Revenue Service focuses on is if the property being acquired is like-kind property to the property that was exchanged.  In order to be of "like-kind", the exchanged properties must be of the same nature or character.  The Chief Counsel Advice (CCA) 201238027 indirectly concluded that the “nature and character” includes the structure and use of the property.  If you trade a piece of land for a piece of land with a building on it, this would not qualify for Like-Kind Exchange treatment as the character is not the same. 

Some Like-Kind Exchanges are very straight forward.  This would be the case in a simultaneous exchange of personal property where both assets are relinquished and received at the same time.  For example, if you go to a car dealership and trade in a Chevrolet Impala for a Ford Focus this would qualify as a Like-Kind Exchange as both assets are like-kind property, both assets are the same nature or character, and were exchanged at the same time.

The rules for Like-Kind Exchanges can also be very confusing and cumbersome.  Take for instance a deferred exchange of real estate.  In a deferred exchange the property you are acquiring has to be identified by midnight on the 45^th day after the taxpayer transfers the property being traded in.  Also the replacement property has to be received by midnight on the earliest of the 180^th day after the taxpayer transfers the property being traded in or the due date (including extensions) for the taxpayer’s return for the taxable year in which the transfer of the property being traded in occurs.

Often times in a Like-Kind Exchange of real estate the taxpayer will use a qualified intermediary.  A qualified intermediary is someone who is not a related party and who expressly agrees to acquire the relinquished property from the seller, transfer the relinquished property to the buyer, acquire the replacement property from a third party and transfer the replacement property to the seller.

Assuming the exchange qualifies, here's how the tax rules work:

In general, if the Like-Kind Exchange transaction is an asset-for-asset exchange, you will not have to recognize any gain from the exchange. You will take the same “basis” (your cost for tax purposes less accumulated depreciation taken on this asset) in your new property that you had in the old property. All Like-Kind Exchanges must be reported on Form 8824 even if you do not have to recognize any gain on the exchange.

Frequently, however, the properties are not equal in value, so some cash or other (non-like-kind) property is also exchanged. This cash or other property is known as “boot.” If boot is involved, you will have to recognize your gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you get in the like-kind property you receive is equal to the basis you had in the property you gave up reduced by the amount of boot you received but increased by the amount of gain recognized.  If you paid something additional (cash or note payable) for the property being acquired then this amount would be added to the “basis” in the property traded in to arrive at your acquired asset’s “basis.”  No matter how much boot is received, you will never recognize more than you’re actual (“realized”) gain on the exchange.

If the property you are exchanging is subject to debt from which you are being relieved, the amount of the debt relief is treated as boot. The theory is that if someone takes over your debt, it is equivalent to his giving you cash. Of course, if the property you are receiving 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).

Like-Kind Exchanges are an excellent tax-deferred way to dispose of investment and trade or business assets. In order to execute them properly all facts and circumstances must be considered.  If you have additional questions or would like to discuss the topic further, contact your tax professional at Dermody, Burke and Brown.

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.