In a like-kind exchange (also called a Section 1031 exchange), you can defer paying taxes upon the sale of property by swapping your property for similar property owned by someone else. The property you receive in a like-kind exchange is treated as if it were a continuation of the property you gave up. The result is that you postpone the recognition (taxation) of gain by shifting the basis of old property to the new property. So you defer paying taxes on any profit you would have received and own new property instead.
Example: Eve exchanges a rental house with an adjusted basis of $250,000 for other real estate held for investment. The fair market value of both properties is $500,000. The basis of Eve's new property is the same as the basis of the old ($250,000). No gain is recognized on the transaction.
You may only exchange property for other similar property, called like-kind property by the IRS. Like-kind properties have the same nature or character, even if they differ in grade or quality. All real estate owned for investment or business use in the United States is considered to be like kind with all other such real estate in the United States, no matter the type or location. For example, an apartment building in New York is like kind to an office building in California.
If you keep exchanging your property for property worth at least as much as yours, you'll never recognize any gain on which you must pay tax. However, sooner or later you'll probably want to sell the replacement property for cash, not exchange it for another property. When this occurs, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. For this reason, a like-kind exchange is tax deferred, not tax free.
Example 1: Assume that five years after the exchange described in the above example, Eve sells her rental house for $800,000 cash. Now she has to pay tax—and quite a lot at that—because she has a $550,000 long-term capital gain. Her gain is $550,000 because her basis in the property is only $250,000 (the basis of the property she exchanged for the building five years earlier). The $800,000 sales price minus the $250,000 basis = $550,000 gain. However, if you convert the last property you exchange into your personal residence, you can permanently exclude up to $500,000 of your gain from its sale. You must own the property for at least five years and live in it for at least two years to qualify for this exclusion.
Example 2: Assume that Eve rents out her house for two years. After the two years of renting the house, she moves in and uses it as her personal residence. She can sell the property any time after five years of ownership, including living there for two years, and pay no tax at all on up to $500,000 of her gain because she is a married taxpayer filing jointly (the exclusion is only $250,000 for single taxpayers).
In practice, it's rarely the case that two people want to swap their properties with each other. Instead, one of the property owners usually wants cash for his or her property, not a swap. This transaction can still be structured as a like-kind exchange. This is often done with the help of a third party called a qualified intermediary or QI, in the business of facilitating like-kind exchanges.
Example: Abe owns a rental triplex he bought for $400,000 and is now worth $500,000. He wants to exchange it for other property instead of selling it and having to pay tax on his $100,000 profit. He puts his property up for sale and in the meantime contacts Carl, a qualified intermediary. Carl locates a small apartment building for sale that Abe likes. Bob, the owner of the building, however, has no interest in exchanging it for other property. Carl and Abe enter into an exchange agreement. Carl purchases Bob's building for $200,000 cash that he borrows and then exchanges it for Abe's triplex. Carl receives a fee for facilitating the exchange and sells Abe's triplex to repay the funds he borrowed to buy Bob's property. With Carl's help, Abe has exchanged his triplex for Bob's building, even though Bob didn't want to do an exchange.
There are strict time limits on such delayed exchanges, which can be more complicated than the above example, involving as many as four parties. You must identify the replacement property for your property within 45 days of its sale. And your replacement property purchase must be completed within 180 days of the initial sale. Because of these time limits, it's a good idea to have a replacement property lined up before you sell your property. Professional exchange companies (also called accommodators or facilitators) can help you find replacement property and handle the transaction for you. You can find listings for such companies through the website of the Federation of Exchange Accommodators.