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Trading property in a 'like-kind' exchange

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.

Like-kind exchanges
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.

Qualifying 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 qualify.

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 by dealers.
  • 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.

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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.

Like property
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 sexes.

Real property
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.

Like-kind 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 of Assets.

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 or profits
  • Two partnerships in which you directly or indirectly own more than 50 percent of the capital interests or profits.

The following table and example explain the consequences of selling a property from a like-kind exchange within two years.

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 .PDF format.

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 deal.

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.

Identification requirement
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 is taxable.)

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.

Reporting the exchange
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.

Computing 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 received.
  • 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 rule
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.

Non-recognition 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 persons.

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

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