Keeping the like-kind exchange file handy could pay off handsomely for corporations.
Allowable under Internal Revenue Code 1031, like-kind exchanges are used to defer the payment of a capital gain on the sale of property or other investments. With a like-kind exchange, the original cost of the relinquished property is transferred to the cost of the replacement property, thereby delaying the payment of the capital gains tax.
Corporations can use the tax law to maximize their return on real estate and other investments. In theory, corporations could use like-kind exchanges to continually benefit from investments without ever having to pay capital gains taxes.
The challenge for finance and real estate executives? Making sure that like-kind exchanges are considered - and used - whenever possible. As such, it's important for corporate executives to keep like-kind exchanges in mind when managing all types of real estate investments. The rule can be implemented in many situations, not just those that are most obvious.
For example, a like-kind exchange could work well when a shortage of cash might be preventing the company from seizing a promising real estate investment. While a company might typically sell existing real estate to raise the funds necessary to purchase new real estate, the gains realized on the sales are subject to high federal and state taxes - sometimes reaching up to 45% of the capital gain. Such penalties are enough to make the executives forget about investing in the new property. By completing a like-kind exchange, however, the corporation could use the entire proceeds on the sale of the property to purchase a new property without paying a single dollar in taxes.
Alternatively, executives should consider using a like-kind exchange when selling a piece of real estate because the company no longer uses or needs the property - even if the corporation has not yet purchased a replacement property. Corporations can avoid the capital gains taxes for a period of up to 180 days, even if the property is sold before the new property is purchased.
Court decisions make it clear that like-kind exchanges are a viable option in complicated situations as well. For example, a like-kind exchange can be used when several investors, as members of a corporation, own a property - and some of the investors sell the property and want to purchase a new property while others simply want to liquidate the investment.
What's more, like-kind exchanges can be used with personal property in addition to real estate. A like-kind exchange can be used when buying and selling:
While the tax benefits of like-kind exchanges are obvious, corporations need to be aware of the intricacies involved in such transactions.
First, to take advantage of this tax provision, the properties being bought and sold need to be of a "like-kind." That is, real property (real estate) must be exchanged for real property and personal property for personal property. The property being exchanged, however, does not have to be exactly the same or of an equal value. For instance, in like-kind exchanges, a large apartment building could be relinquished while a single-family home is purchased or a vacation rental property could be relinquished while a dental office building is purchased.
Under the law, the complete transaction must take place within a certain period, but it does not have to be a simultaneous swapping. The estate property could be sold at the beginning of the period - and then the replacement property purchased at the end of the six-month period. However, a list of 1031 qualified exchange properties must be identified shortly after the process.
Another tax provision even allows investors to purchase the new property before the relinquished property is sold. With these reverse like-kind exchanges, the entire transaction must still take place within a set time-frame.
To successfully complete a like-kind exchange, a “qualified intermediary” must hold the money from the first settlement. A “qualified intermediary” is a person who enters into a written agreement with the taxpayer to acquire relinquished property from the taxpayer, transfer that property to the purchaser, acquire replacement property, and then transfer the replacement property to the taxpayer. The exchange may be completed without the cooperation of the purchaser of the property. The taxpayer's relatives, accountant, broker, or attorney cannot serve as qualified intermediaries.
Armed with an understanding of like-kind exchanges and a working knowledge of how to execute such exchanges, corporations can maximize their return on investments while minimizing their capital gains tax bill.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.