Like Kind Exchanges of Real Estate

By: Frank J. Schmidt
Lashly & Baer, P.C.
Copyright 2006

The sale or transfer of appreciated real estate generally creates a tax consequence in the form of gain recognition for the owner of the property sold. However, a “like kind exchange” is a tax planning tool that allows the property owner to defer the recognition of gain (or loss, if applicable) on that property if it is exchanged for other property that is of "like kind."

The legal authority for like kind exchanges of real estate is found in the Internal Revenue Code, which states:

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

To further explain and illustrate the proper application of this law, we can break it down into four major components:

First, there must be an exchange of real estate. This seems straightforward, but frequently is not because typically, more than two parties are involved.

The most common form of tax-free exchange occurs when an owner wants to sell real estate (the “relinquished property”) and invest the proceeds of sale in other real estate of like kind (the “replacement property”), but the replacement property is owned by someone other than the purchaser of the relinquished property. When this is the case, an accommodation party (usually a qualified, professional intermediary) must be employed so the transaction retains the exchange characteristic that is essential for tax free treatment. . The accommodation party will acquire the replacement property in “exchange” for the proceeds from the sale of the relinquished property, which either has been or soon will be sold to a third party, and then immediately transfer the replacement property to the now former owner of the relinquished property. The most critical part of this scenario is that owner of the relinquished property is never treated as having received the sale proceeds.

But what if the owner has not yet identified the replacement property at the time he/she sells the relinquished property? In this event, the owner can proceed with the sale of the relinquished property and still receive tax-free exchange treatment as long as: (a) the replacement property is properly identified within 45 days after the sale of the relinquished property, and (b) the owner purchases the replacement property on or before the earlier of: (i) 180 days after the sale of the relinquished property, and (ii) the due date of the owner’s tax return for the year in which the relinquished property is sold.

Second, the relinquished property must have been used for trade or business or held for investment purposes. Generally speaking, real estate held for personal use (i.e. a primary residence) does not qualify, which is usually a straightforward determination.

Third, the replacement property must be of "like kind" to relinquished property. Treasury regulations state that "like kind" refers to the "nature or character of the property and not to its grade or quality." For example, improved real estate can be of like kind to unimproved real property as long as the improvements only relate to grade or quality.

Even if properties are clearly of like kind, they often are of unequal value. Such a transaction can still qualify as a tax-free exchange as long as any cash or non-qualifying property (i.e. “boot”) received is recognized as income by the receiving party.

Fourth, the replacement property must continue to be used in a trade or business or held for investment purposes. One of the issues owners of replacement property face is the length of time they must they hold that property after the like kind exchange is completed so the exchange is not disqualified from tax free treatment. Arguably, other provisions of the like kind exchange rules under the Code may determine this component. For example, the law states that anyone receiving real estate from a related party (as further defined in the Code) as a part of a like kind exchange must hold that replacement property for at least two years to qualify the exchange for tax free treatment.

Anyone contemplating a tax-free exchange should consult a tax professional before attempting a like kind exchange.