A business or individual can dispose of appreciated real property without being taxed on the gain by exchanging it. You can defer tax on your gain through a “like-kind” exchange or the Internal Revenue Code Section 1031.
What’s a Like-Kind Exchange?
A like-kind exchange is a swap of real property held for investment or for productive use in your trade or business for like-kind investment real property or business real property. “Like-kind” is very broadly defined, and most real property is considered to be like-kind with other real property. Although, neither the relinquished property nor the replacement property can be real property held primarily for sale. Contact us if you’re unsure if the involved property is eligible for a like-kind exchange.
How Tax Rules Work
You don’t have to recognize any gains from asset-for-asset exchanges. You’ll take the same “basis” (your cost for tax purposes) in the replacement property that you had in the relinquished property. However, you still have to report the exchange on a form that is attached to your tax return.
Some properties often aren’t equal in value, so some cash or other (non-like-kind) property is thrown into the deal. This cash or other property is known as “boot.”
When a boot occurs, you recognize your gain up to the amount of boot you receive in the exchange. The basis you get in the like-kind replacement property you receive is equal to the basis you had in the relinquished property you gave up reduced by the amount of boot you received but increased by the amount of any gain recognized.
The Like-Kind Exchange Math
Let’s say you exchange land (investment property) with a basis of $100,000 for a building (also investment property) valued at $120,000 plus $15,000 in cash. Your realized gain on the exchange is $35,000.
You received $135,000 in value for an asset with a basis of $100,000. However, since it’s a like-kind exchange, you only have to recognize $15,000 of your gain: the amount of cash (boot) you received. Your basis in the new building (the replacement property) will be $100,000, which is your original basis in the relinquished property you gave up ($100,000) plus the $15,000 gain recognized, minus the $15,000 boot received.
Note: You’ll never recognize more than your actual (“realized”) gain on the exchange regardless of the boot value.
Other Boot Implications
Debt is treated as a boot if the property you’re exchanging is subject to debt from which you’re being relieved. If someone takes over your debt, it’s equivalent to him or her giving you cash. Of course, if the replacement property is also subject to debt, then you’re 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).
A business can dispose of investments, trade or assets through like-kind exchanges. Please contact us if you have any additional questions or need assistance with a transaction.