Deferring Capital Gains with a Like-Kind Exchange

Recently, a client consulted with our firm to represent him in the sale of his commercial rental property. Considering the property’s appreciation and the tax depreciation that the client had taken over the years, the sale of the real estate was going to result in a $500,000 capital gain to the client.

In discussing the transaction with the client, we learned that he intended on purchasing another rental property with the sale proceeds, but had yet to find the right building. Additionally, as expected, he was interested in suggestions on structuring his sale to reduce his capital gain as much as possible. Even considering the prospect of capital gains tax relief in the pending federal tax bills, the sale was to generate a potentially large tax liability. We suggested structuring the transaction as a like-kind exchange, allowing the client to defer the large capital gain.

Like-Kind Exchange

A like-kind exchange refers to a property 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.

Conceptually, the like-kind exchange provision is based on Congressional reluctance to impose a tax when a property owner is not “cashing out” his investment, but merely replacing his investment with a similar investment. To impose a tax where, by the nature of the transaction, the taxpayer will not have liquidity to pay the tax, would be extraordinarily burdensome. Thus, Code §1031 allows the taxpayer to defer the capital gain until his investment is ultimately liquidated.

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, depending upon the type of exchange that is being structured in order to obtain the deferral treatment.

Two such requirements apply to all like-kind exchanges. First, the exchange must involve either investment property or property that is part of the owner’s trade or business. Investment real estate, whether held as a speculative investment or as a rental income generator, is commonly exchanged in like-kind transactions. Investment securities, such as stock, bonds or partnership interests, and inventory are specifically ineligible for like-kind exchange treatment.

The second requirement of all like-kind exchanges is that the property exchanged must be considered “like-kind.” The interpretive Treasury regulations provide guidelines for determining when property can be considered “like” another property. For example, the regulations provides that a computer is considered to be “like” a printer, but an airplane is not considered to be “like” a general purpose truck. Where two businesses exchange a group of assets, the exchange is treated as an exchange of each individual asset and can be considered a like-kind exchange only if each asset transferred is replaced with a similar asset

Simultaneous Exchange

Once the assets to be exchanged are determined, the transaction can be structured. 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. For this type of transaction, the only statutory requirements are that both the relinquished property and the replacement property must be held for investment purposes and be similar in character.

While a simultaneous exchange can be structured between two just property owners, it may be unusual for two property owners who want to exchange like-kind assets to find each other. In such a case, the transaction can be structured among three or more property owners. In a triangular three party exchange, for example, three property owners exchange their respective properties among themselves. Each party would end up owning the property of his choice without recognizing a capital gain on the disposition of his original property.

Deferred Exchange

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.

Structuring a deferred like-kind exchange can be more complex than a simultaneous exchange. The Code provides three additional requirements for a deferred exchange, in addition to the two statutory requirements of a simultaneous exchange discussed above. First, 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. The escrow funds are to be used to purchase the replacement property or, if the property owner fails to find a replacement property within the allotted time period, the intermediary may pay the escrow funds to the property owner, who will, naturally, have to recognize the capital gain.

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” under the safe harbors set forth in the Treasury regulations. Generally, a person who has acted as the property owner’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within two years of the transfer of the relinquished property cannot serve as the intermediary, as the Treasury regulations treat such an individual as the property owner’s agent. In order to be considered qualified, the intermediary must not have rendered services to the property owner, other than in connection with the like-kind exchange.

A second requirement for a deferred exchange 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, in writing, of potential replacement properties. The identification may list a single replacement property or several potential properties, one of which will ultimately become the replacement property. The Treasury regulations provide guidelines on the detail required for a proper identification.

To provide some limit to the identification of potential replacement properties, the Treasury regulations impose restrictions with regard to the number or value of potential replacement properties the property owner can identify. 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. Care should be taken in counting the actual number of days lapsed, as the statute provides no relief for miscalculating the number of days.

When the property owner is set to close on the replacement property, it is not necessary for the intermediary to actually take title to the replacement property. The property owner, instead, can have legal title to the replacement property transferred directly to him. In such case, the purchase price for the replacement property could be paid by the intermediary directly from the escrow account.

Timing of the Transaction

The time to decide whether or not to structure a transaction as a like-kind exchange is prior to the sale of the relinquished property. A like-kind exchange can be structured even if the property owner has an agreement to sell the relinquished property, as long as the sale has not closed with the property owner receiving the sale proceeds. Where the sale is pending, the purchase and sale agreement can be assigned to an intermediary, who will facilitate the sale. It is essential in such a transaction for the sale proceeds to be paid directly to the intermediary and not the seller.

If a property owner structures his property disposition as a like-kind exchange and subsequently decides not to replace his investment property, the property owner can intentionally fail to qualify the transaction as a like-kind exchange and, instead, receive the sale proceeds. Obviously, any capital gain on the sale would be due as if the transaction was not structured as a like-kind exchange.

It is not possible to structure a like-kind exchange if the property owner has already purchased the replacement property. While at one time there was some question whether a so-called “reverse like-kind exchange” would qualify for tax deferral, the Treasury regulations now clearly state that such a transaction would not qualify for tax deferral treatment.

Tax Deferral

Although like-kind exchanges are often referred to as tax-free exchanges, the capital gain is not actually eliminated but is merely deferred. Mechanically, 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, on the other hand, the sale of the relinquished property would generate a capital loss, a like-kind exchange would be inappropriate as the loss would be deferred.

Conclusion

The Tax Code and the interpretive Treasury regulations and rulings provide great detail of the requirements of a like-kind exchange and should be consulted prior to structuring a like-kind exchange. If the transaction is not properly structured, the property owner may be surprised to learn that the capital gain must be reported when the property is sold.