Tax-Free Exchange and Like-Kind Exchange

Tax-Free Exchange - Avoid Paying Capital Gains Taxes Now

Tax-free exchange is a tax deferred exchange in which one pays capital gains taxes for exchange of a property not when the transfer takes place, but on a later date. Pursuant to Internal Revenue Code Section 1031, recognition of taxes on capital gains or losses on exchange of like-kind property can be deferred to a subsequent date.

A tax-deferred exchange allows deferring the tax on capital gain or loss that arises when selling or buying a property. Deferment of tax may apply if one sells a property and uses the income to buy a like asset. In a tax free property exchange, properties are exempted from capital gains tax if they are of like-kind in nature even though of different quality. In a tax-deferred, like-kind exchange, the parties will have to sign a tax free exchange addendum which forms part of a real estate contract.

1031 tax free exchanges are structured transactions that link together the sale of an old asset and the purchase of a new asset for the purpose of deferring taxes. 1031 exchanges are mainly used for selling and buying of real estate. Generally tax free exchanges are used in connection with sales of like-kind real property. However, sometimes personal property exchanges can also be considered as a tax-free exchange.

Usually, in a 1031 exchange, an investor will sign an offer to purchase agreement with a qualified intermediary (QI), and the property to be invested will be put on the market. 1031 tax free exchange rules require that within first forty-five days after the escrow on the sale of the relinquished property is closed, the investor should identify replacement properties. Further, within 180 days after the close of escrow on the sale of the relinquished property, the investor should close the sale on one of the replacement properties which he has identified. This completes the exchange.

The IRS Code does not allow extension for the forty-five day replacement period in a tax free exchange of property. However, under Treasury regulations, certain property transferred along with the larger item of value that does not exceed fifteen percent of the fair market value need not be identified within the forty-five day period.

Make sure not to confuse a 1031 exchange with a 1035 tax free exchange, which permits the direct conveyance of accumulated funds in an insurance policy to another insurance policy by deferring tax to a subsequent date.

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