With housing prices softening and interest rates at all-time highs, now is a good time to consider creative strategies for diversifying your real estate portfolio. Like-kind exchanges present one such opportunity.
What is a Like-Kind Exchange?
IRC Section 1031 outlines the requirements and restrictions for a like-kind exchange. When the rules outlined in Section 1031 are properly applied, you can exchange one investment property for another without triggering a taxable event. Thus, you can defer payment of taxes on the sale of existing property by investing the equity into a new property. Keep in mind, this option is only available for “real property” (variably defined by each state) within the United States.
Many different types of investments can qualify as real property, and while their use must be similar, their quality may vary. Some properties to consider under a like-kind exchange can include apartment buildings, single-family rental properties, vacation rental homes, restaurant rental spaces, or commercial office rental space. Since these options are all considered rental investments, they may be considered as similar assets in a like-kind exchange.
What Steps Should I Take in a Like-Kind Exchange?
The like-kind exchange process has a fairly quick turnaround. Within 45 days of the sale of your property you must identify, in writing, replacement property to be acquired. You can identity up to three replacement properties without regard to value. If you identify more than three properties, you must follow the “200% Rule.” The 200% Rule outlines that you may identify as many properties as you wish if the total fair market value does not exceed 200% of that of the original property.
You will have total of 180 days to complete a like-kind exchange once you have relinquished your original property.
To process the property transaction, we highly recommend working with a Qualified Intermediary (QI). A like-kind exchange is more of a trade, rather than a sale, as you should not access any sales proceeds in the process. Any proceeds to you (the taxpayer) from a relinquished property will be immediately taxable. However, a QI can process the transactions so that you do not hold onto any proceeds.
What Are the Benefits of a Like-Kind Exchange?
Like-kind exchanges are most ideal for taxpayers in a high tax bracket, as federal income taxes would be deferred on the exchanged properties. However, any real estate investor can benefit from a like-kind exchange. Below are some of the valuable benefits of conducting a like-kind exchange.
- There is no limit to the number of like-kind exchanges you can perform. Thus, you have the opportunity to continually exchange properties over time.
- Even with the softening of the real estate market, many taxpayers find that they have significant equity in their property. Selling your current real estate investment and buying new properties in different markets can diversify your real estate holdings.
- Tax rates can change annually, so, with a proper like-kind exchange, 100% of these taxes are deferred.
- With the Washington State capital gains tax being collected in 2023, you can defer the gain and potential state tax by entering a like-kind exchange.
- With the flexibility of real property, you have an increased likelihood of exchanging one property for another.
What Can a Like-Kind Exchange Look Like?
I’ll outline an example of a like-kind exchange for you:
Imagine you currently have a commercial office rental space, but there is a trend of companies transitioning to a work-from-home model. Leasing out your office space has become less reliable, but you are seeing an increase in tourism in your area. Your office space has a market value of $500,000 and you’ve found two amazing residential properties that you could rent out: one vacation home for $350,000 and one single-family home for $150,000.
First, you will want to identify a Qualified Intermediary to facilitate an exchange so that you’re not holding any sale proceeds. Next, you’ll relinquish your office rental space to the QI. Within the first 45 days of this relinquishment, your QI will identify the new vacation home and single-family home as the properties to exchange. You’ll use the next 135 days to close on both new properties, totaling a combined value of $500,000, equaling the fair market value of your relinquished office rental space. Finally, the QI will pass these two properties to you to complete the exchange, which you would file in that year’s tax return.
A like-kind exchange is an ideal process if you are looking to diversify your real estate portfolio. By using a Qualified Intermediary and following the like-kind exchange rules, you can defer 100% of the federal income taxes associated with property sale. If you need a QI or have questions about processing a like-kind exchange, Clark Nuber can help. Send me an email and I would be happy to talk more about saving money in real estate.
Want to learn more accounting solutions for real estate investors? Check out my article Real Estate Investors: What to Ask Your CPA.
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