WHAT is a Like-Kind Exchange?
A Like-Kind Exchange is a tool for real estate investors. However, anyone with a type of investment property can benefit from a Like-Kind exchange, and New Jersey residents engaged in their own estate planning should discuss the possibility with their estate planning attorney.
Let’s consider whether you might benefit from such an exchange.
A Like-Kind Exchange is also known as a 1031 exchange. It takes its name from the section of the U.S. Internal Revenue Code after which it is named, section 1031. Normally a strategic tool for real estate investors, it allows the deferral of capital gains taxes when one property is exchanged for another property of like-kind.
A Like-Kind Exchange occurs when the owner of one investment property swaps it for another investment property of similar nature or character. That is the “like-kind” requirement. Examples of properties that may qualify include things like a rental home, a vacant lot, an office building, or an apartment complex.
The key requirements of the deal are:
- Both properties are held for investment purposes, not personal purposes.
- The exchanger has 45 days to identify a replacement property and 180 days to complete the exchange. In this way, an executor on behalf of a decedent or a beneficiary can dispose of an asset and acquire another without generating a capital gains tax liability from the sale of the first asset.
Like-Kind exchanges are an excellent estate planning tool, particularly for investors. With a Like-Kind exchange, heirs can receive properties with a stepped-up basis to the fair market value at the time of the decedent’s death. That can eliminate the capital gains taxes when the heirs receive and even sell the property.
WHO can use Like-Kind Exchanges?
New Jersey residents who own investment or business properties can utilize a Like-Kind exchange to avoid capital gains taxes. Such owners may also use a Qualified Intermediary (QI) to sell one property and purchase another property (or multiple properties) without incurring a current income tax liability. Potential sellers should note however, that both the original and replacement properties must be held for use in a trade, business, or for investment. The sale of a personal residence does not qualify. A rental property must be rented at least 24 months prior to the exchange.
WHERE May This Occur in New Jersey?
In New Jersey, any real estate held for productive use in a trade or business or for investment purposes is considered like-kind. Both properties in such an exchange must be in the United States.
WHEN Must a Like-Kind Exchange be Completed?
A 1031 Like-Kind Exchange must be completed within 180 days. Specifically: You have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you, and delivered to a person involved in the exchange. The entire transaction must be completed within 180 days.
HOW is a Like-Kind Exchange Accomplished?
The process involves three key steps:
- Before the sale: The property owner must retain a Qualified Intermediary (QI), who acts as a fiduciary to receive the proceeds directly from the sale.
- Within 45 days: The property owner must identify the property (or properties) to be purchased. The identification is made to the QI in writing.
- Within 180 days: The property owner must close title on the replacement property within 180 days following the sale of the relinquished property.
WHY Undertake a Like-Kind Exchange?
The benefits of a Like-Kind Exchange are attractive:
Tax Benefits:
- An investment property owner can use a Like-Kind Exchange to defer payment of capital gains taxes, giving him or her more money to invest in another property. In effect, as the owner-exchanger, you receive an interest-free loan from the federal government for the amount you would have paid in taxes.
- If you simply sell the property as opposed to exchanging it, you will pay between 25-40% of your profits on taxes to the government that year. That would include federal and state capital gains tax, depreciation recapture, and the possible 3.8% net investment income tax due.
Estate Planning Advantages:
- Stepped-up basis at death: The 1031 exchange allows you to defer capital gains taxes until after your death. When the property is sold after your death, the property can then take advantage of being “stepped-up” to the fair market value for capital gains taxes. This means that, when your heir(s) sell the property, their realized gain will be calculated based on the fair market value of the property at the time your heir(s) inherited it, thereby eliminating a portion of the tax burden.
- Dividing assets among heirs: You can divide your properties by following this process: You would sell each property and use all of your profits to purchase new investment property. Working with your legal counsel, each property could be placed into its own revocable living trust with one of the children being named as the beneficiary of the trust. When you pass away, each property would automatically transfer to the named beneficiary, free of taxes and with a stepped-up basis equal to the value of the property at the time of death.
- Permanent tax avoidance: Tax can be permanently avoided if the replacement property is held until the owner dies. The beneficiaries inherit the property at a “stepped-up” basis equal to the value at the date of death and never have to pay income tax on the profit.
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