If You Own Real Estate, Like Kind Exchanges May Be a Tax Strategy to Consider
by Ronald L. Bissonnette, Esq.
As tax season draws nearer to us, our thoughts turn to ways in which we can reduce taxes. One strategy to consider if you own real estate and are considering purchasing additional real estate is Like Kind Exchanges. The following is a summary of how Like Kind Exchanges work.
Deferring the payment of taxes on real estate indefinitely is the goal of like kind exchanges. The goal is accomplished by following rules established by the I.R.S. to treat what would otherwise be a sale as an exchange of property.
For example, Taxpayer owns a building used for the manufacture, storage and retail sale of window treatments. The manufacturing part of the business is expanding and Taxpayer sees little need to retain the high visibility retail location. He needs more room for manufacturing. He could sell the current site for $250,000 and buy a building in the industrial park for $300,000. Unfortunately, his accountant has advised him that his basis in the current site is only $50,000. Taxpayer will pay a 20% Federal income tax on the $200,000 gain or $40,000. The State of Maine will also receive its share of taxes.
By following the rules for a tax deferred like kind exchange, Taxpayer will defer recognizing any gain until he sells the new building in the industrial park, if ever. The rules are complicated and must be followed scrupulously. This type of transaction should only be attempted with the assistance of a qualified professional with experience in conducting tax deferred exchanges.
The following are some of the requirements to qualify for tax deferral.
A. Property Must be of a Like Kind. In the case of real estate any real estate exchanged for other real estate will qualify. For example, a manufacturing plant could be exchanged for a condominium unit. Personal property is less straightforward. The Service requires personal property to be nearly identical (i.e., a toaster for a toaster and not a toaster for a blender). Therefore, like kind exchanges are more appropriate for real estate transactions, and most of them are real estate transactions.
B. Property Must be for Business or Investment. The relinquished property must have been held for productive use in a trade or business or for investment. It must be exchanged for replacement property which is to be held either for productive use in a trade or business or for investment.
The Exchange Made Easy
A. Two-Party Exchanges are Impractical. The most simple example of an exchange is a two-party exchange. The taxpayer finds property she wants and exchanges her relinquished property directly with the owner of the desired property for the replacement property. The obvious difficulty with this transaction is finding a desirable property whose owner is willing to trade for the taxpayer’s property.
B. Use of a Qualified Intermediary Makes the Exchange Work. A qualified intermediary is a person who is not the taxpayer or a disqualified person. The intermediary enters into a written agreement with the taxpayer and acquires the relinquished property from the taxpayer. The intermediary sells the relinquished property and uses the proceeds to acquire the replacement property. The intermediary transfers the replacement property to the taxpayer thus completing the exchange.
Among the persons and entities who are disqualified from being an intermediary are persons who within the two-year period ending with the transfer of the relinquished property have acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker. Services rendered to the taxpayer with respect to like kind exchanges do not disqualify a person. Also, persons related by blood or marriage within certain degrees to the taxpayer and persons who share certain business interests with the taxpayer are disqualified.
A taxpayer can defer both Federal and Maine income tax on capital gains indefinitely by exchanging property. By using a qualified intermediary, the taxpayer can accomplish an exchange nearly as as a simple sale and purchase. There is no reason not to use an exchange unless you simply enjoy paying taxes.
Ron Bissonnette is a partner with the law firm of Isaacson & Raymond in Lewiston. Ron specializes in real estate, business law and estate planning.
[from The I & R Connection Volume 1; Issue 1 - Winter 1999]