31.3 Exchanging Real Estate Without Tax

You may exchange real estate held for investment for other investment real estate and incur no immediate tax consequences. On a fully tax-free exchange of “like-kind” property, you do not recognize any gain realized on the exchange and you cannot deduct any loss. If you had a gain, the potential tax on the gain is postponed until you sell the new property for more than your basis. A tax-free exchange may also defer a potential tax due on gain from depreciation recapture and might be considered where the depreciable basis of a building has been substantially written off. Here, the building may be exchanged for other property that will give larger tax deductions.

Planning Reminder

Exchanging a Building for Land

A tax-free exchange may be advantageous in the case of land. Land is not depreciable, but it may be exchanged for a depreciable rental building. The exchange is tax free and depreciation may be claimed on the building. However, be aware of a possible tax trap if you exchange rental property for land and the building was subject to depreciation recapture: The recapture provisions override the tax-free exchange rules. The “recapture element” will be taxable as ordinary income.

- - - - - - - - - -

Fully tax-free exchanges.

To transact a fully tax-free exchange, you must satisfy these conditions:

• The property traded must be solely for property of a “like kind.” The words like kind are liberally interpreted. They refer to the nature or character of the property, not its grade, quality, or use. Some examples of like-kind exchanges are: farm or ranch for city property; unimproved land for improved real estate; rental house for a store building; and fee in business property for 30-year or more leasehold in the same type of property (6.1). However, you may not make a tax-free exchange of U.S. real estate for real estate in foreign countries; your gain or loss on the exchange must be recognized.
• The property exchanged must have been held for productive use in your business or for investment and traded for property to be held for productive use in business or investment. Therefore, trades of property used, or to be used, for personal purposes, such as exchanging a residence for rental property, cannot receive tax-free treatment. However, if you rent out your vacation home and meet the conditions of an IRS safe harbor (6.1), the residence is treated as investment property rather than personal-use property, so it can be part of a like-kind exchange for other investment property.

• The trade must generally occur within a 180-day period, and property identification must occur within 45 days of the first transfer (6.4).

A real estate dealer cannot transact a tax-free exchange of property held for sale to customers. Also, an exchange is not tax free if the property received is held for immediate resale.

Tax-free exchanges between related parties are subject to tax if either party disposes of the exchanged property within a two-year period (6.6).

Disadvantage of tax-free exchange.

Although the postponement of tax on gain from a tax-free exchange is equivalent to an interest-free loan from the government equal to the amount you would have owed in taxes had you sold the property, this tax advantage is offset by a disadvantage in the case of an exchange of depreciable real estate. You must carry over the basis of the old property to the new property; see the following Example.

Planning Reminder

Loss Deduction

A tax-free exchange is not desirable if the transaction will result in a loss, since you may not deduct a loss in a tax-free exchange. To ensure the loss deduction, first sell the property and then buy new property with the proceeds.

- - - - - - - - - -

Partially tax-free exchanges.

To be completely tax-free, the exchange must be solely an exchange of like-kind properties. If you receive “boot,” such as cash or property that is not of like kind, gain is taxed up to the amount of the boot.

If you trade mortgaged property, the mortgage released is treated as boot (6.3). When there are mortgages on both properties, the mortgages are netted. The party giving up the larger mortgage and getting the smaller mortgage treats the excess as boot. Taxable boot cannot exceed the amount of your gain. See the Example below and also the Example in 6.3, which illustrates how to report an exchange on Form 8824.