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Trading places: Avoid tax on like-kind exchange

by on
in Small Business Tax,Small Business Tax Deduction Strategies

It may be possible to dispose of appreciated real estate property without paying a single penny of tax.  

Strategy: Use a like-kind exchange of properties. If handled properly, you don’t have to pay any tax until you sell your replacement property, if ever.

However, you must pay close attention to the tax law deadlines.  

Here’s the whole story: Under Section 1031 of the tax code, you can defer a taxable gain when exchanging properties that are similar in nature, except to the extent you receive any “boot” as part of the transaction. Then you must pay current tax on the gain up to the amount of the boot.

Both the property being relinquished and the property being acquired must be investment or business property. You can’t swap personal-use property on a tax-free basis.

The IRS takes a liberal view of what constitutes “like-kind” property for this purpose. For example, you can swap a commercial building for raw land or an apartment building.

Better to give than receive?

If properties of differing values are being exchanged, one party may add boot, such as cash or other property, to the deal. If you receive boot, you owe current tax on the amount equal to the lesser of:

  • The realized gain (i.e., the difference between the basis of the property being given up and the fair market value of what is received in exchange, including any boot)
  • The fair market value of the boot.

On the other hand, if you’re the one paying the boot, at least you won’t have to recognize any taxable gain.

Don’t ignore 2 tax deadlines

To qualify for a tax-free treatment for a like-kind exchange: You must identify (or actually receive) the replacement property within 45 days of transferring legal ownership of the relinquished property.

1. The title to the replacement property must be transferred to you within the earlier of 180 days or your tax return due date, plus extensions, for the tax year of the transfer.

2. The 180-day period begins to run on the date of the transfer of legal ownership of the relinquished property. If that period straddles two tax years, it might be cut short by the tax return due date.

Example: If you gave up title to the relinquished property on Dec. 1, 2011, the April 17, 2012, due date for 2011 returns would arrive before 180 days are up.

Tip: If you relinquished property with a larger mortgage than the replacement property, the difference is generally treated as taxable boot.

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