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A like-kind exchange refers to property (e.g. equipment or real estate) transfer structured under section 1031 of the Internal Revenue Code (the "Code"). In a like-kind exchange, a property owner exchanges his investment property (the "relinquished property") for another investment property (the "replacement property") and, if properly structured, the property owner will not recognize the capital gain inherent in his property. Instead, the gain is essentially "rolled over" and deferred until the newly acquired replacement property is subsequently sold. As the capital gain deferral is the exception rather than the general rule, the Code contains several specific requirements with which the property owner must comply. First, the exchange must involve either investment property or property that is part of the owner's trade or business. The second requirement of all like-kind exchanges is that the property exchanged must be considered "like-kind." A like-kind exchange can be structured either as a simultaneous exchange between two or more property owners or as a sale by a property owner followed by a subsequent purchase of a replacement property. In a simultaneous exchange, two or more property owners exchange their properties in one transaction. The problem with structuring a simultaneous exchange is that the property owner must have identified his replacement property in advance of disposing his relinquished property. It is more likely that the property owner selling his property will not have identified the replacement property in advance. In such a case, a deferred like-kind exchange may be appropriate. In a deferred like-kind exchange, a property owner sells his property to a third party, who pays the purchase price to an intermediary or escrow agent. The intermediary holds the sale proceeds in escrow and later, when the property owner has identified and negotiated for the purchase of the replacement property, the intermediary uses the escrowed funds to purchase the replacement property. In a deferred exchange, the taxpayer may not control or take possession of the sale proceeds from the relinquished property. The intermediary's role, in a deferred exchange, is to facilitate the transaction by placing the sale proceeds in escrow. As the seller will be deemed to have control over the sale proceeds if the intermediary is considered the seller's agent, it is imperative that the intermediary be "qualified". A second requirement is that the property owner must identify a replacement property within 45 days of the sale of the relinquished property. The identification process involves the property owner informing the intermediary of potential replacement properties. According to the regulations, the property owner can either identify three potential replacement properties of an unlimited value or an unlimited number of potential replacement properties the total value of which does not exceed 200% of the value of the relinquished property. For example, if the relinquished property is valued at $1 million, the property owner can either identify three potential replacement properties of unlimited value or several potential replacement properties, up to $2 million in value. Finally, to qualify as a deferred exchange, the taxpayer must acquire the replacement property within 180 days of the disposition of the relinquished property. The actual replacement property must have been listed as a potential replacement property during the identification period. Although like-kind exchanges are often referred to as tax-free exchanges, the capital gain is not actually eliminated but is merely deferred. Basically, the property owner's basis in his replacement property is calculated by reducing the purchase price by the capital gain that has been deferred. If, in addition to giving up like property, money is paid in a like-kind exchange, there still is no taxable gain or deductible loss. The basis of the property received is the basis of the property given up increased by the money paid. Depreciable tangible personal property can be either "like kind" or "like class" to qualify for nonrecognition treatment. Like-class properties are depreciable tangible personal properties within the same General Asset Class (Tax Code) or Product Class (SIC Code). For exchanges of property after June 8, 1997, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind property under the like-kind exchange rules. Example. A tractor held for investment that has an adjusted basis of $8,000 is exchanged for another truck. The truck received has a fair market value of $10,000. You also receive $1,000 in cash. You paid $500 in exchange expenses. Although the total gain realized on the transaction is $2,500, only $500 ($1,000 cash received minus the $500 exchange expenses) is recognized. |
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