Investing in real estate can assist you in diversifying your investment portfolio by adding physical assets and providing you with a hedge against inflation. If you are a real estate investor, or if you aspire to become one, you will want to know about like-kind exchanges because they give you a chance to shift your real estate investments on a tax-deferred basis. Like-kind exchanges give you the opportunity to have a dynamic real estate portfolio that you can adjust based on the market and the economic conditions without incurring a large tax liability. Here is how they work.
If you’re looking for counsel on diversifying your portfolio or adding physical assets to your holdings consider working with a financial advisor.
Like-Kind Exchange, Definition
A like-kind exchange happens when an investor wants to sell real estate and avoid the capital gains tax that would normally be assessed. The investor can use the like-kind exchange to sell a parcel of real estate and buy another parcel as long as the parcel they buy is similar to the parcel they sell. A like-kind exchange is authorized as a Section 1031 exchange under the Internal Revenue Code (IRC). Both the like-kind exchange and like-kind property are defined under Section 1031.
Like-kind property is composed of real estate assets that are so similar in nature that they qualify for a like-kind exchange. The Internal Revenue Code defines a like-kind property as any held for investment, trade, or business purposes under Section 1031. Grade of the assets or quality of the assets is not used to determine like-kind property. Personal property cannot be used in a like-kind exchange. The gains of the transaction are not tax-exempt. They are tax-deferred.
Section 1031 of the IRS Code exempts the seller of the property from paying capital gains as long as the property is for business and investment purposes. The seller must purchase like-kind property every time they sell property in order to defer taxes for the longest time period possible.
Like-Kind Exchange, Types
There are four types of like-kind exchanges:
- Simultaneous – The simultaneous exchange is reasonably simple. It is the simultaneous exchange of one qualifying property for another with the transaction closing that day.
- Deferred – The deferred exchange may be the most common. The seller sells the property and has 45 days to identify the property that will be exchanged for it. Then, the seller has 180 days to complete the sale. An exchange facility is often used to facilitate the deferred exchange to be sure it doesn’t become a taxable event.
- Reverse – A reverse exchange occurs when the property that will be the replacement property is acquired and the seller has 180 days to sell the original property.
- Improvement – An improvement exchange requires that the property that is acquired be placed with an intermediary for 180 days while construction or improvement occurs.
Like-Kind Exchange, Conditions & Rules
Several conditions must be met for a property to qualify for an exchange. The property must be used in a trade, business or investment. Personal property does not qualify. The property must be like-kind to the property it is replacing. Usually, real estate is like-kind to other real estates as long as neither parcel is for personal use. Using an exchange facility for the transaction helps ensure that a mistake is not made regarding the personal property issue.
There are also a set of rules that must be followed when doing an like-kind exchange.
- When the replacement property is finally sold, that’s when the tax on the capital gain is paid.
- Only business or investment property can be exchanged as of the enactment of the Tax and Jobs Act of 2017.
- The exchange must be identical in nature.
- The replacement property must be of the same or higher in value.
- The owner of the original and replacement property must be the same person.
- The property must be acquired in 45 days and the transaction closed in 180 days.
The Bottom Line
Real estate investors, dealing in frequent real estate transactions, should take advantage of like-kind exchanges when they can. Since real estate is usually like-kind for other real estates, the rules may not be as hard to follow as it appears. The most difficult issue may be the relatively short time frames to complete the acquisition and closing the deal.
Tips on Investing
- Investors contemplating a like-kind exchange should carefully think through the pros and cons. That’s where a financial advisor can be invaluable. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’ve decided to craft your investment portfolio alone, you should make sure you’re prepared. SmartAsset has you covered with a number of different online investment resources to help you figure things out. Check out our free asset allocation calculator today.