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Like-kind Exchange

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Definitions

A like-kind exchange (LKE), also known as a 1031 exchange, swap, tax-deferred exchange or Starker exchange, allows businesses to defer recognizing the taxable gain when they sell an asset and purchase a “like-kind” asset.

Section 1031 of the Internal Revenue Code (26 U.S.C. § 1031) dictates that exchanges of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due. Section 1031 has been part of the Internal Revenue Code since 1921. It can be used for industrial equipment, real estate or other business assets.

[edit] Types of Like-kind Exchanges

In a simultaneous exchange, two companies exchange like-kind assets at the same time.

Delayed exchanges are the most common type of exchange. There’s a time gap between when the asset is sold and replaced. Businesses have 180 days to finish the exchange or pay the tax. A qualified intermediary must be involved in this transaction to facilitate the exchange (see Qualified Intermediary below).

Build-to-suit (improvement or construction) exchanges allow businesses to build on or make improvements to the replacement property, using sales proceeds from the original asset.

In a reverse exchange, the replacement asset is acquired before the original asset is sold. The exchanger may continue using the original asset until the exchange is finalized.

Personal property exchanges let the business take an asset, like a crane or wheel loader, and exchange it for other assets that are like-kind or like-class. It’s important to note that “like-kind” doesn’t mean the assets have to be exactly the same – a wheel loader is like-kind to a crawler tractor. The replacement property may be new or used.

[edit] How Like-kind Exchanges are Conducted

In order to conduct an LKE, businesses work through a qualified intermediary (QI). Under a written exchange agreement with the exchanger, the QI acquires the relinquished property or asset and transfers it to a buyer. The QI holds the cash, as required by the Internal Revenue Code (IRC). Finally, the QI acquires the replacement property or asset and transfers it to the taxpayer, completing the exchange.

The QI ensures that IRC regulations are followed. These rules dictate that the taxpayer may not receive or have constructive receipt of the proceeds in any way. This will disqualify the exchange.

The Qualified Intermediary does not actually take title to property or assets in most situations. Property can be deeded or licensed between the parties as in a normal sales transaction.

A taxpayer has 45 days after the date the property or asset is transferred to a buyer to purchase or identify replacement property. If the taxpayer makes this identification, the timeline is extended by 135 days or until the tax filing for that year. This brings the total timeline to 180 days, or six months.

There is no limit to the number of exchanges that can be done. Generally a company can exchange as many properties or assets as it wants, but there are strict deadlines to follow in order to maximize these exchanges. Section 1031 Exchanges can continue repetitively for as long as the taxpayer continues to buy and sell “like-kind” assets. It’s this rolling of exchanges that maximizes cash flow benefit and creates an indefinite deferral.

Benefits of Like-kind Exchanges

By deferring taxes, companies can retain their cash – which can be up to 40% of the sale price – which is then invested in other pieces of equipment, real estate or business assets. Some people compare it to an interest-free loan from the federal government.