You may have heard of a "tax-free exchange" of real estate, a concept that has definite appeal. This tax provision allows you to dispose of rental (or other business use or investment use) property without triggering an immediate tax bill on the gain. And you don't really have to hope that the owner whose property you want just happens to want your property, too. Three-way deals can be arranged that appear an awful lot like buying and selling—but count as trading if specific IRS rules are followed. And, recent changes in the law have simplified the process. In addition, the rules allow an intermediary to broker the exchange. In that case you never meet the person you are exchanging the property with.
If you trade property for property of a "like kind," the IRS does not treat your disposal of your property as a sale. Like kind is liberally defined. Clearly, exchanging a rental house for another rental house is covered, but so is trading raw land for an apartment building. The advantage is that you hold off the tax bill on your profit from the first property.
Consider an example. Say you have a rental house with an adjusted basis of $50,000 and that it is now worth $150,000. You'd like to expand your rental activities by buying a duplex with a price tag of $250,000. If you sell the first house, you'll owe tax on $100,000 of profit. That will cost you somewhere between $15,000 and $25,000, depending on how much of the profit is attributable to depreciation deductions and therefore taxed at 25% and how much gets the lower, 15% rate for long-term capital gains.
Instead, assume you enter into an exchange for a $250,000 duplex for your $150,000 house plus $100,000 in cash. As long as the deal qualifies as a tax-free exchange, you avoid the tax tab.
Avoid is really too strong a term. Defer is more accurate. Your basis in the new building would not be its $250,000 price but rather your old $50,000 basis plus the $100,000 cash you had to put into the deal. When you later sell the duplex—assuming you don't work another tax-free exchange—the gain would be based on your $150,000 basis. That would give the IRS its delayed shot at the $100,000 of profit that built up in the first house.
Since, in this example, the owner of the duplex received cash as well as like-kind property, it's not a totally tax-free exchange for him. Part or all of his profit (the difference between his basis in the property and the $250,000 value of your building plus cash) would be taxable. He would owe tax on the lower of his total profit or $100,000 (the amount of cash received). His basis on the rental house would be reduced by any part of the $100,000 that wasn't taxed in the year of the trade.
Although holding off Uncle Sam is always an appealing prospect, like-kind exchanges have disadvantages. For one thing, your depreciation deductions on the new property will be held down because you carry over the basis from old property. Also, if you use a like-kind exchange in a year in which you have suspended passive losses, you'll miss the chance to absorb some of those losses.
To qualify as tax-free, the exchange must take place within a specified time frame. You must identify the property you're going to receive within 45 days of transferring your property, and the deal must generally be completed within 180 days. Note, too, that the tax advantages can be lost if the exchange is with a related person (brother, sister, parent, grandparent, child, grandchild) and either property is disposed of within two years of the trade.
In 2004, Congress added a new restriction to the like-kind exchange rules to prevent taxpayers of mixing different parts of the tax law to take what it considered an unfair advantage. Let's say you use a like-kind to trade one rental property for another and then convert the new property into your principal residence. Generally, you can exclude up to $250,000 of gain on the sale of a home ($500,000 if you are married and file a joint return), provided you have owned and used it as a principal residence for two out of the five years before the sale. The new rule holds that if you acquire your home with a like-kind exchange, you get no exclusion at all if you sell within five years. The new law applies to sales after October 22, 2004.
Exchanges are not limited to real estate. Any property used for business or investment purposes can be exchanged for another property used for business or investment purposes as long as the exchanged properties are the same kind. To qualify the acquired asset needs to be from the same asset class as the property being given up. Therefore, a truck used for business cannot be exchanged for a machinery (also used in business)since they are not in the same asset class as defined for depreciation. There are other restrictions that are outlined in IRS Publication 544 "Disposition of Assets."