Dear Tax Talk,
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What are the rules for like-kind exchanges? If one sells a rental property and does a like-kind exchange for another property, can the new purchase be two to three properties that would equal the sold property's value? Or does it have to be just one property of at least the value of the sold property?
Like-kind exchanges are truly one of the best tax loopholes for the average investor. The problem is that you have to keep trading up on property values to avoid taxation. For example, if you bought a property that cost $100,000 and it has increased in value to $250,000, you have a $150,000 gain if you sell it. If you exchange it for another property worth $100,000, the entire $150,000 in gain is taxable. That is, any amount not reinvested is considered to come from your gain first and then the recovery of your original cost.
Continuing the example, if you reinvested $75,000, your maximum taxable amount is still your $150,000 gain. The other $25,000 not reinvested is considered to be a return of your original $100,000 investment. Lastly, if you reinvest $240,000, the $10,000 not reinvested is gain that will be recognized. There is no proration.
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If you don't feel it makes economic sense to reinvest all the proceeds, you're stuck recognizing gain. However, if you could buy more than one property, the economics could be more advantageous. For example, I've seen investors get better returns on $50,000 properties than $250,000 properties.
Under the exchange rules, there is no limitation on the number of replacement properties. However, you are limited to identifying within 45 days either:
- Three properties of any value.
- Any number of properties so long as they don't exceed 200 percent of the value of the relinquished property.
Continuing the example, under these limits you could replace the relinquished property with five to 10 $50,000 units, as it doesn't exceed twice the value under rule No. 2 above. Alternatively, you could identify three properties A, B and C, each worth $200,000, and be within the limits of No. 1 above.
Of course, with the looming fiscal crisis, capital gains taxes may never be as low as 15 percent again. You may want to forgo like-kind exchanges if you don't see yourself as a landlord forever.
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