Trading property in a 'like-kind'
June 14, 1999 -- Are you a small business owner
trying to reduce your tax bill? Certain types of barters, or exchanges,
aren't subject to taxes or losses. The most common type of nontaxable
trade is the like-kind exchange. The first part of this tax tip
explains the conditions a trade must meet to be considered "like-kind."
IRS requirements are also clarified, particularly those applying
to like-kind exchanges made between related persons.
The second part of this tax tip addresses situations
that require a small business to recognize all or part of a realized
gain in the current year. Small business owners need to understand
how to calculate the gain realized from such an exchange, as well
as know when they are required to recognize a gain immediately.
The effects of possible changes in debt status on tax liability
are also clarified. Strategies presented here for exploiting any
tax-deferred gains, such as passing the property through an estate,
will also be of concern to small business owners.
The most common type of nontaxable exchange involves swapping property
for the same kind of property. For the exchange to be "like-kind,"
the property traded and the property received must be both qualifying
property and like property.
In a like-kind exchange, both the property relinquished
and the property received must be held by you for investment or
for productive use in your trade or business. Machinery, buildings,
land, trucks and rental houses are examples of property that may
Exchanges of the following properties aren't
eligible for like-kind rules:
- Property you use for personal purposes, such
as your home and your family car.
- Stock in trade or other property held primarily
for sale, such as inventories, raw materials and real estate held
- Stocks, bonds, notes or other securities
or evidence of accounts receivable.
- Partnership interests.
- Certificates of trust or beneficial interest.
If you completed one of the above exchanges
with visions of a tax break, don't despair. It may still qualify.
Check "Other Nontaxable Exchanges" in IRS Publication
544: Sales and Other Dispositions of Assets.
Also, keep in mind that exchanging the assets
of a business for the assets of a similar business isn't treated
as an exchange of one property for another. Qualifying for tax treatment
as a like-kind exchange depends on an analysis of each asset involved
in the exchange.
There must be an exchange of like property. An exchange
of real estate for real estate is an exchange of like property.
The trade of land improved with an apartment house for land improved
with a store building, or a panel truck for a pickup truck, is also
a like-kind exchange.
Exchanging personal property for real property
isn't a like-kind exchange. Neither is an exchange of a piece of
machinery for a store building or the exchange of livestock of different
Exchanges of real property are more likely to qualify for like-kind
treatment. Exchanging city property for farm property or improved
property for unimproved property is a like-kind exchange.
Be careful, though. All exchanges of interests
in real property don't qualify for like-kind treatment. The exchange
of real estate you own for a real estate lease that extends 30 years
or more is a like-kind exchange. However, the exchange of a lifetime
interest in a property expected to last less than 30 years for an
interest that doesn't kick in until later isn't a like-kind exchange.
exchanges between relatives
Like-kind exchanges between related persons are subject
to special rules. For more information on related persons, see "Nondeductible
Loss" under "Sales and Exchanges Between Related Persons"
in Chapter 2 of IRS Publication 544: Sales and Other Dispositions
Disposing of property any sooner than two years
after the exchange makes it taxable, and your tax liability must
immediately reflect the gain or loss on the original exchange.
In this situation, the IRS consider a related
person to be:
- You and a member of your family, such as
your spouse, brother, sister, parent or child.
- You and a corporation in which you have more
than 50 percent ownership
- You and a partnership in which you directly
or indirectly own more than a 50 percent interest of the capital
- Two partnerships in which you directly or
indirectly own more than 50 percent of the capital interests or
The following table and example explain the
consequences of selling a property from a like-kind exchange within
The price you paid for something -- or the value
of the property you traded for it -- isn't necessarily the item's
value in the eyes of the IRS, which says the purchase price or trade
value must be adjusted. The resulting value is referred to as the
adjusted basis. The rules for determining an adjusted basis vary
according to the type of property involved. For more information,
see "Adjusted Basis" in IRS Publication 551, which
is available on the IRS Web site in
If you trade a truck you use in your pool maintenance
business for the station wagon your sister uses in her plumbing
business, the transaction is a like-kind exchange and neither of
you carries a tax burden -- unless one of the vehicles is sold within
two years of the trade.
If that happens, the numbers kick in, so let's
take a look at what to expect: Say that, in Dec. 1998, you exchanged
your truck and $200 in cash for your sister's station wagon. At
that time, the fair market value of your truck was $7,000 and the
fair market value of your sister's station wagon was $7,200. By
adding $200 cash to the deal you evened it out to a fair trade.
Or did you?
The government requires that you consider the
fair market value of the item you receive -- but the adjusted basis
of the item you relinquish. Suddenly the equation shifts.
Your truck had an adjusted basis of $6,000,
so you relinquished $6,200 (the adjusted basis of the truck and
the value of the cash) in exchange for $7,200 (the fair market value
of your sister's station wagon.) Hence, you gained $1,000 in the
By the same token, your sister relinquished
$1,000 (the adjusted basis of her station wagon) and received $7,200
(the fair market value of your truck and the value of the cash you
handed her). So she gained $6,200.
If you then sell the station wagon, the deal
becomes taxable for you and your sister -- both. You will also be
responsible for any taxes due as a result of the subsequent sale.
Not all trades see the two sides of the exchange completed
on the same day. If you relinquish property before you receive anything
in exchange, you have only 45 days from the time you complete your
half of the deal to notify the IRS of the property that will be
received. If it comes in within the 45 days, the IRS automatically
assumes it completes the original transactions. (Beware: If, before
the swap is completed, you receive anything other than the item
you were to receive in trade, the whole affair becomes a sale and
If you transfer more than one property as part
of the same exchange and the properties are transferred on different
dates, the identification period and the receipt period begin on
the date of the first transfer.
Report the exchange of like-kind property on Form 8824. The form's
instructions explain how to report the details. You must report
the exchange even though no gain or loss is recognized. Use Schedule
D to report sales, non-like kind exchanges and other dispositions
of capital assets.
If you have any taxable gain because you received
money or unlike property, report it on Schedule D (Form 1040) or
Form 4797, whichever applies. Refer to Chapter 4 of IRS Publication
544: Sales and Other Dispositions of Assets for additional information.
the realized gain from an exchange
While many like-kind exchanges aren't subject to taxes
or losses, there are situations that require a small business to
recognize all or part of a realized gain in the current year. If
your like-kind exchange is one that requires recognizing a gain
in the current year, compute your tax-deferred realized gain:
- Take the fair market value of the property
- Add cash or additional property received.
- Add the value of any debt secured by the
property you are relinquishing.
- Subtract the adjusted basis of the old property.
- Subtract the value of any debt secured by
the new property.
- Subtract the cash or additional value relinquished.
An exception to every
If you need to see something in return for the property you relinquished
-- but the other half of the exchange isn't ready to go through,
a qualified intermediary can simplify the exchange process.
Using a qualified intermediary means you can
sell the old property to -- and buy the new property from -- different
people. A qualified intermediary collects the payment from the buyer
of the old property and keeps the payment in a qualified exchange
account. Once you acquire the replacement property, the qualified
intermediary pays the seller of the new property.
rules are mandatory
When used correctly, the tax-deferred aspect of a like-kind exchange
immediately benefits you. But what if you actually want to pay taxes
on a realized gain or loss? You will have to modify the exchange
so that it's taxable.
You also need to remember that the property
exchange is tax-deferred as opposed to tax-free. The like-kind exchange
does decrease the adjusted basis for the new property. However,
you will have to pay the piper once you sell the property. The value,
for tax purposes, of the property remains unchanged as long as you
hold it. Which means there is a good chance it will be valued at
less than market value if you hold it for a period of time.
Can you legally avoid paying the taxes due on
this substantial gain? The ideal strategy for the new property,
or any property for which it is subsequently exchanged, is to avoid
selling it. If possible, hold on to it and pass it through to your
estate. Your heirs won't use your lower tax basis to compute the
gain from selling this property. Instead, they receive a "stepped-up"
basis. This means that their gain will be based on the fair market
value on the date of your death, instead of on the date you acquired
it. Assuming they sell the property shortly after your death, your
heirs will recognize little or no capital gain from this sale since
their basis will be close to the current sales price.
Small business owners searching for another way to legally
reduce their taxes should consider conducting a like-kind exchange.
The first part of this tax tip explains the conditions an exchange
must meet to be considered "like-kind," and emphasizes
special rules applying to like-kind exchanges made between related
There are exchanges that require the recognition
of all or part of a realized gain in the current year. The change
your small business's debt status is what determines the basis of
the acquired property. This tip also provides several strategies
for making the most of tax-deferred gains from these exchanges,
including passing this property through an estate.
-- Posted June 14, 1999