Written by Sarah Fordyce, CPA 

In the current real estate market, many investors selling properties are receiving offers well above the list price and original purchase price. At face value, this is a positive, as investors are receiving large returns on their investments. 

The downside is the large tax gains on these sales. If the taxpayer sells for a higher value than the original purchase and they’ve received ordinary tax benefits through depreciation, they could face a significant tax bill, potentially negating the large cash deposit received upon sale. 

One way to defer a potentially large tax gain is a like-kind exchange. These exchanges have seen increased popularity over the years as investors respond to increasing real estate values. When done correctly, like-kind exchanges can help taxpayers defer their tax gain while buying new real estate in the process. 

Key Exchange Rules 

To complete a successful like-kind exchange and take advantage of the opportunity to defer the tax gain, there are rules that must be followed. If these guidelines aren’t met, the taxpayer won’t qualify for gain deferral and will need to pay tax on the full value. 

• Taxpayer must use a qualified intermediary: This individual sells the property on your behalf, collects the cash, then uses that cash to purchase new property. 
• The intermediary must receive the cash: To qualify for gain deferral, the intermediary, rather than the taxpayer, must receive the cash from closing. 
• 45 days to identify new properties: Within 45 days from the sale of the property, the taxpayer must identify the properties they would like to purchase. 
• Selection constraints: The taxpayer doesn’t need to purchase all identified properties, but the properties they ultimately purchase must have been among those identified. 
• 180 days to close on new properties: Taxpayers have 180 days from the initial sale to close on the new properties that were identified. This timeline runs concurrently with the 45-day identification timeline. 

Additional Requirements 

If all the guidelines listed above are met, the taxpayer is eligible to defer their tax gain. However, to fully defer the gain, further requirements must be met: 

• Purchase property of equal or greater value: The new property purchased needs to have a value similar to the property sold, or greater. 
• Incur debt of equal or greater value: Any debt paid off when the original property was sold needs to be incurred on the new property. This can be a new loan or new cash paid by the taxpayer. 
• Avoid receiving any cash: Taxpayers must use all the cash held by the intermediary to purchase the new property. Any leftover cash will be taxable. 

If the replacement property meets all these requirements, the full gain can be deferred. If any of these requirements aren’t met, some of the gain could be taxable but would still qualify for a successful exchange. 

Types of Exchanges 

The most common exchange occurs when the taxpayer sells a property and then purchases a new property — called a forward exchange. However, there are several more like-kind exchange types that must meet the previously explained rules and requirements to qualify for full gain deferral. 

• Reverse like-kind exchange: Occurs when a taxpayer finds a property they want to purchase before selling an existing property, requiring them to follow a few additional rules, as both properties can’t be owned simultaneously. The taxpayer is required to work with a qualified intermediary and exchange accommodation titleholder to purchase the new property. Then, the property to be sold must be identified within 45 days and sold within 180 days. Once the property is sold, the intermediary uses the funds to pay off any loans on the new property and then transfers the title to the taxpayer. 
• Improvement exchange: Occurs when a taxpayer wants to purchase a new investment property that needs significant improvements or a fully new building and include the improvement costs in the like-kind exchange. These are considered improvement exchanges and can be forward or reverse exchanges. The requirement making these exchanges more difficult is that the improvements or construction must be completed within the 180-day timeframe to qualify the costs in the exchange. This does not mean the full construction needs to be completed in 180 days – only the improvements completed within that timeframe qualify. 

Final Thoughts 

Like-kind exchanges can be powerful strategies to help real estate investors defer the tax impact of selling property while also building and diversifying their portfolio. With many rules and requirements to ensure the gain is fully deferrable, it’s important to consult a qualified tax advisor when looking to complete one of these exchanges.