Like-kind property exchanges can reduce tax bite

Practice Pointers. By Cathy B. Goldsticker, AMNews contributor. June 20, 2005.

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Question: To augment my personal income from my practice, I own several rental real estate properties. Because of the strong real estate market, and the cash flow my properties generate, their fair market values have risen significantly. I am tempted to sell them but don't want to affect my investment return with a tax bite on the gains. I understand that I can make a property swap and defer the tax. What is involved in the swap, and do you recommend it?

Answer: The transaction you are pursuing is a like-kind exchange under Internal Revenue Code Section 1031. It has been in our tax laws since 1921 and is an effective way of protecting your equity in your real estate investments from capital gain taxes.

A like-kind exchange allows the taxes due on a real estate sale to be deferred (not eliminated) as long as qualified replacement property is purchased. In fact, if the rules of Section 1031 are followed, the deferred tax application is a mandatory, not an optional, tax result. The method for opting out of the like-kind exchange rules is to not fulfill the many onerous tax law requirements of this code section.

To qualify for deferred tax treatment on your sale of real estate, it is important that the sale and purchase contracts include exchange cooperation language. Language should include your intent for the transactions to qualify under the exchange tax laws. In addition, your relinquished and replacement properties must be "like-kind." To be like-kind, under the tax laws, the two properties must be similar in nature or character. All real property is generally like-kind to each other. This relaxed definition of like-kind makes exchange transactions very attractive for real estate.