Like-Kind Exchanges - Summary Explanation

General Information

The exchange of property for the same kind of property is the most common type of non-taxable exchange. To be a like-kind exchange, the property traded and the property received must be both of the following:

  1. Qualifying property
  2. Like-kind property

Additional requirements apply to exchanges in which the property received is not received immediately upon the transfer of the property given up. These are known as Deferred Like-Kind Exchanges, and are the more common type.

If the like-kind exchange involves the receipt of money, or unlike property, or the assumption of liabilities, then some of the gain may have to be recognized. This is often known as a Partially Non-taxable Exchange, and the excess proceeds are often known as boot.

When you acquire property in a like-kind exchange, the tax cost basis of that property is the same as the basis in the property that was transferred away. In the case of a partially non-taxable exchange, the basis in the new property is usually adjusted as a result of the taxable portion of the transfer.

If, in addition to giving up like-kind property, you need to pay money as part of the like-kind exchange transaction, you still have no recognized gain or loss. However, the basis in the property received is the basis of the property given up, increased by the amount of money paid.

Exchange expenses are generally the closing costs that you pay - including such items as brokerage commissions, attorney fees, intermediary fees, deed preparation and registration fees, and transfer taxes. Subtract these fees from the consideration received to determine the amount realized on the exchange. Also, add them to the basis of the property received. If you receive cash or unlike property in addition to the like-kind property and realize a partial or full gain on the exchange, subtract the expenses from the cash or the fair market value of the unlike property - and so use the net figure to calculate the gain that will be subject to tax.

Qualifying Property

In a like-kind exchange, both the property you give up and the property you receive must be held by you for investment or for productive use in a trade or business. Buildings, land, and rental houses are typical examples of property that may qualify for like-kind treatment.

The following specifically do not qualify:

Machinery, equipment, and vehicles
Property used for personal purposes, such as home or cars
Stocks, bonds, securities, debt instruments, receivables
Partnership interests
Certificates of trust or beneficial interests in trusts
Stock in trade, inventories, raw materials held for sale
Real estate held by dealers or developers for sale
Business interests - depends on individual assets within the business

Like-Kind Property

Like-kind properties are properties of the same nature or character, even if they differ in grade or quality. The exchange of real estate for real estate, is an exchange of like-kind property. For example, the exchange of land improved with an apartment building for land improved with a store building is a like-kind exchange.

An exchange of personal property for real property, or vice versa, does not qualify as a like-kind exchange.

An exchange of city property for farm/rural property, or improved property for unimproved property, can be a like-kind exchange.

An exchange of real estate for a real estate lease that runs 30 years or longer can be a like-kind exchange. However, this area can be complicated, as not all exchanges of interests in real property will qualify. For example, an exchange of a life estate for a remainder interest usually will not qualify. But note, an exchange of a remainder interest in one real estate for a remainder interest in another real estate, if the nature or character of the two property interests is the same, may qualify.

Real estate located outside of the United States is generally not considered like-kind property under these rules. If you exchange foreign real property for property located in the United States, your gain or loss on the exchange will be recognized. There may be some limited exceptions for condemned real property.

Deferred Exchange Issues

A deferred exchange is one in which you transfer property and later receive the replacement property - and is the more common method of like-kind exchanges involving real estate. The transaction must be an exchange, and cannot be a transfer of property for money used to buy the replacement property.

Please note: if, before you receive the replacement property, you actually or constructively receive money or unlike property in full payment for the property you transfer, then the transaction will be treated as a sale and the gain will be taxable - even if you later receive the replacement property, which would then be treated as a purchase.

You constructively receive money or unlike property when the money or property is credited to your account or made available to you. You also constructively receive money or unlike property when any limits or restrictions on it expire or are waived. This issue needs to be monitored carefully to ensure that no inadvertent violation occurs.

Whether you actually or constructively receive money or unlike property, however, it is determined without regard to certain arrangements you may make to ensure that the other party carries out its obligation to transfer the replacement property to you. For example, if you have that obligation secured by a mortgage, or by cash held in a qualified trust or escrow account, that arrangement will be disregarded in determining whether you actually or constructively received any monies or unlike property.

Qualified Intermediary

Because of the significant pitfalls inherent with deferred exchanges, the use of a Qualified Intermediary provides a safety net against like-kind exchanges failing because of the cumbersome steps needed in coordinating the two transactions.

A Qualified Intermediary is a person who enters into a written exchange agreement with you to acquire and transfer the property you give up, and to acquire the replacement property and transfer it to you. This agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of the money or other property held by the Qualified Intermediary.

If you transfer property through a Qualified Intermediary, the transfer of the property given up and the receipt of the like-kind property are treated as an exchange.

The following cannot be a Qualified Intermediary:

  1. Your agent at the time of the transaction.
  2. Any person who has been your employee, attorney, accountant, investment banker, broker, or real estate agent within the two year period before the transfer of the property that you give up.
  3. Any person that is a related party to you or to your agent.

A Qualified Intermediary is treated as acquiring and transferring property if all of the following requirements are met:

  1. The intermediary acquires and transfers legal title to the property.
  2. The intermediary enters into an agreement with a person other than you for the transfer to that person of the property you give up, and that property is transferred to that person.
  3. The intermediary enters into an agreement with the owner of the replacement property for the transfer of that property, and that replacement property is transferred to you.
  4. An intermediary is treated as entering into an agreement if the rights of a party to the agreement (your rights) are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment by the date of the relevant transfer of the property.

Identification Requirements

You must identify to the Qualified Intermediary the property to be received within 45 days after the date that you transfer the property given up in the exchange - which is the date that the property has been assigned to the Qualified Intermediary. Any property actually received during that 45 day period is considered to be de facto identified.

If you transfer more than one property as part of the same transaction, and the properties are transferred on different dates, the identification period and the receipt period begin on the date of the earliest transfer.

You must identify the replacement property in a signed written document and deliver it to the Qualified Intermediary involved in the exchange. You must clearly describe the replacement property in the written document. For example, use the legal description and street address for real estate. In the same manner, you can cancel an identification of replacement property at any time before the end of the identification period.

You can identify more than one replacement property. Regardless of the number of properties that you give up, the maximum number of replacement properties that you can identify is the larger of the following:

  1. Three
  2. Any number of properties whose total fair market value at the end of the identification period is not more than double the total fair market value, on the date of transfer, of all the properties that you give up.

If the replacement property has not yet been produced or built at the time of identification, it may still qualify as a like-kind exchange, but there are complex rules that will need to be observed and followed.

Receipt Requirement

The replacement property or properties must be received by the earlier of the following dates:

  1. The 180th day after the date on which you transfer the property given up in the exchange. If more than one property was given up, then it is the 180th day after the earliest transfer. Please note that 180 days is NOT six months, and must be measured to the day.
  2. The due date, including extensions, for your tax return for the year in which the transfer of the property given up occurs. For transfers occurring in the last few months of any calendar year, it may be prudent to extend the filing of a tax return in order to ensure the full 180 days are available, if needed.

Other Comments

There are other possibilities to complete like-kind exchanges using Qualified Exchange Accommodation Arrangements, but these are beyond the scope of this general summary. Also, the rules for multiple property exchanges, partially non-taxable exchanges, and limited related party exchanges, are extensive and rather technical. Specific advice should be sought if contemplating one of the more esoteric like-kind transactions.

Pragmatic Procedural Steps

  1. Taxpayer finds a buyer for a property, negotiates a sale, and signs a purchase and sale agreement to sell to the prospective purchaser.

  2. Taxpayer enters an exchange agreement with a Qualified Intermediary.

  3. Taxpayer assigns the Purchase and Sale agreement to the Qualified Intermediary. This starts the 45 day and 180 day periods.

  4. Qualified Intermediary notifies all parties in writing of the assignment, and advises the Taxpayer of the deadline for identifying the replacement property or properties.

  5. Qualified Intermediary closes on the sale as appropriate and retains control of the funds pending acquisition of the replacement property.

  6. Taxpayer identifies replacement property, negotiates acquisition terms and price, and notifies Qualified Intermediary thereof within the 45 day identification period.

  7. Qualified Intermediary enters into an agreement with the owner of the replacement property to complete the transfer of the property to the Taxpayer.

  8. The replacement property is actually transferred within the replacement period of 180 days.

(The information in this article is a summary and should not be viewed as a substitute for the law and/or the regulations.)