What is a Like Kind Exchange?

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Generally, if you sell your land, you will owe taxes on the purchase price you receive.  However, by using a transaction known as a like-kind (or section 1031) exchange, you may be able to defer taxes if you exchange one parcel of land for another. The two properties do not have to be identical—the landowner can exchange city real estate for a ranch, an empty lot for one with townhouses, or a conservation easement for farmland.

An exchange must satisfy a number of requirements before it can qualify for this tax benefit. Most importantly, the properties involved must be held for investment or for the productive use in a trade or business, such as agriculture or forestry. An individual cannot use his personal residence for a like-kind exchange. Also, the exchange must be done through a safe harbor, such as through a qualified intermediary, so that you do not take possession of any funds before being transferred the other property.

An experienced tax professional can help you structure a transaction in such a way to satisfy the tax rules.

Example

Meet Bob Burns, he bought a house in a suburban development as an investment, not to live in. A few years later, the undeveloped farmland next door to his parent’s farm went up for sale. Bob decided that he’d like to follow his father into farming.  Rather than selling his property, paying taxes on the sale, and using the remaining funds to purchase the farmland, Bob can exchange his suburban lot for the farmland.  While he will have to report the transaction to the IRS (Download IRS form),  Bob will not owe any taxes until he sells the new property. 
 
If the owners of the farm don’t want Bob’s suburban house, Bob can still use a like-kind exchange. The tax rules allow for a neutral party —known as a qualified intermediary (QI) — to purchase property from Bob within certain time limits (45 days for identification and 180 days for exchange). Bob can sell the house in the suburban development and the proceeds from the sale will go to the QI.  Then the intermediary can then use the funds to purchase the farm for Bob.
 
If the properties are worth different amounts, such as if the farm is worth more than the suburban lot, Bob will have to provide the additional money to the intermediary, known as boot, to cover the price difference between the two properties.  If Bob’s suburban house is worth more than the farm, the additional money would remain in his intermediary fund to be either used to buy more property or if not used, it would ultimately become boot, and taxable in the eyes of the IRS.  While he will defer taxes in the first scenario, Bob will owe some taxes in the second scenario if he doesn't use the extra money for a purchase, although not as much as he would have if he hadn’t done a like-kind exchange. 
 
How it works: If you choose to use a QI, which is recommended, the QI must qualify under the requirements of the safe harbor provision. This will ensure that you will not be in receipt of the funds and will qualify for a 1031 exchange. Instead, the sale proceeds go directly to the QI, who holds them until they are needed to acquire the replacement property. The QI then delivers the funds directly to the closing agent. If there is a boot involved, the QI will greatly simplify the transaction.