Tax-Free Exchanges for Rental Property

Do you own rental property? Anything from a strip mall, multifamily home, office building, or factory can be a potential profit center for you. If you want to cash in on appreciation you’ve experienced in your property over the past several years but don’t want a pay a big tax bill, consider trading the property for another. As long as the trade confirms to tax law rules for a “like-kind” exchange, you can postpone your gain, enabling the full value of the old property to be reinvested in new property that working for you.

Like-kind property

To qualify for this exchange treatment, both the property you’re disposing of (old property) and the one you’re getting (replacement property) must be of “like-kind”. This means that the nature or character of the property must be the same. For example, exchanging one type of real property for another is viewed as like kind, even if one is proved and the other unimproved, or one building is brand new and the older old.

Direct swaps

If you locate property that’s of equal value to yours and the owner is willing to swap, you can become the owner of that property with no immediate tax cost to you. This is so no matter how much your property has appreciated since you acquired it.

The gain not recognized because of the tax-free exchange rule reduces your basis in the property. This effectively preserves the gain so you’ll recognize it when you ultimately sell the replacement property in a taxable transaction. For example, say you bought property for $200,000 that is now worth $800,000 and you exchange it for like-kind property valued at $800,000. Your gain of $600,000 is not immediately taxed. The basis of your replacement property is $200,000 (the $800,000 minus the $600,000 gain not yet recognized).

Often, however, property being exchanged is not identical in value. If you receive cash in addition to replacement property, the cash, called “boot,” is taxable to you to the extent of the gain in your property. (Boot need not be cash and can be any non-like-kind property, but cash is most common.)

If you must pay money in addition to your property in order to trade evenly for the replacement property, this doesn’t change your current tax treatment. You simply add the cash you paid to your tax basis.

Nonsimultaneous exchanges

You may want to make a swap but be unable to locate suitable property immediately. You can work with a company that facilitates such exchanges. As long as you don’t receive the cash proceeds for the sale of your property and meet certain timetables, you qualify for like-kind exchange treatment.

• You must identify potential replacement properties within 45 days of giving up title to your property.
• You must complete the exchange (receive title to replacement property) within 180 days of giving up title to your property.

Note: The rule for these so-called “deferred exchanges” are complex. It’s best to work with a knowledgeable real estate advisor to ensure that the tax rules are met.