Under the new Tax Cuts and Jobs Act (TCJA), like-kind exchanges of commercial or investment real estate properties remain exempt from tax. However, things usually aren’t so cut-and-dried in the real world. For one thing, it’s unlikely the potential buyer of your property will own any real estate you desire.
Strategy: Use a “qualified intermediary” to facilitate deals. The intermediary can be inserted in the middle of a multiple-party exchange. In the end, you wind up with a property you want.
Like-kind exchanges are often called “Starker exchanges” after the landmark case approving their use. (Starker, 602 F2d 1341, 9th Cir., 1979) As long as you can meet the tax law rules and deadlines for a Starker exchange, you can swap property tax free.
Here’s the whole story: The tax law definition of like-kind real estate property is a relatively liberal one. It refers to the nature of the property, not its quality or grade. For example, you can swap a warehouse tax free for an apartment building or even raw land. You owe tax only to the extent you receive any “boot” as part of the deal (e.g., cash or reduced mortgage liability or property that is not like-kind).
But there are two key time restrictions:
- The property that you will receive in the exchange must be identified within 45 days of transferring the property.
- The property must be received within the earlier of 180 days after the transfer or due date of the tax return for that year (including any extensions of the due date).
Fortunately, a qualified intermediary can help you overcome these timing hurdles.
Example: You use a qualified intermediary for a Starker exchange involving four parties. Technically, you (the first party) sell the property you’re relinquishing to a cash buyer (the second party). But the cash buyer pays the intermediary (the third party) instead of you. The intermediary holds the proceeds until you identify a suitable replacement property.
At that point, the intermediary uses the sales proceeds to buy the replacement from its owner (the fourth party). Finally, the intermediary transfers this property to you to complete the like-kind exchange.
For tax purposes, you’re considered to have swapped properties tax free with the intermediary. That’s because no cash actually exchanges hands (except to the extent cash boot is involved). The intermediary handles the funds on your behalf.
To qualify for tax-free treatment, you and the qualified intermediary must sign a “Qualified Exchange Accommodation Agreement.” The agreement should state that the intermediary is holding the property to facilitate a tax-free exchange. The intermediary must also agree to meet all the technical reporting requirements spelled out by the IRS.
Tip: Qualified intermediaries generally charge fees based on the value of the properties. Factor this into your decisions.
IRS carves out safe-harbor rule
The IRS has approved a “safe-harbor rule” for participants in a Starker exchange when a qualified intermediary defaults due to bankruptcy. (IRS Revenue Procedure 2010-14)
The upshot: If you satisfy the requirements, you won’t be taxed on any of the proceeds until the intermediary emerges from bankruptcy. The safe-harbor rule applies if you:
- Transferred relinquished property to the intermediary in accordance with the regs
- Property identified replacement property within the identification period (unless the default occurs during that period)
- Failed to complete the like-kind exchange solely because of the default involving bankruptcy or receivership
- Did not have actual or constructive receipt of proceeds from any property of the intermediary prior to the bankruptcy or receivership.
Tip: Any gain will then be realized under a gross profit ratio method. See your tax professional.
Small Business Tax Strategies