If you own highly appreciated business or investment real estate, you may worry about being hit with capital gains tax when you sell it. But there may be a way out: a “like-kind” exchange.

Under Section 1031 of the Internal Revenue Code, you may exchange business or investment property (the relinquished property) for like-kind business or investment property (the replacement property) without recognizing any gain or loss until you dispose of the replacement property.

Below are answers to some common questions about this tax-deferral opportunity.

How Do They Work?

The IRS generally allows three types of like-kind exchanges:

1. Direct swaps. Two investors may simply agree to exchange properties. Any non-real-estate property that changes hands as part of the transaction — because one property is worth more than the other — may be taxable. These deals are rare; it usually takes time to find a replacement property to buy or to sell a property in your existing portfolio.
2. Deferred exchanges. Here, relinquished property is transferred before the acquisition of the replacement property. In the interim, a qualified intermediary must be engaged to hold the proceeds and execute the exchange. The replacement property must be identified within 45 days of when the relinquished property is transferred. In addition, the replacement property must be acquired within 180 days of the transfer of the relinquished property or by the due date of the applicable tax return (including extensions) for the year in which the relinquished property is transferred, if sooner.
3. Reverse exchanges. In this scenario, you acquire the replacement property first and then “park” it with an exchange accommodation titleholder before the relinquished property is transferred. The timing rules are similar to those for deferred exchanges: The property you’ll relinquish must be identified within 45 days of when the replacement property is acquired, and the transfer of the relinquished property generally must be completed within 180 days of when the accommodator receives the replacement property

For all three types of like-kind exchanges, a qualified intermediary must be involved and is essential to completing a valid exchange.

What Qualifies Under Sec. 1031?

The IRS is fairly flexible on what property can be exchanged under this tax break. For example, you can swap an apartment building for a strip mall. Or you can swap one business or investment property for multiple replacement properties. You can even exchange one business or investment property for a tenancy-in-common interest in a pool of larger properties, thereby opening the door to professionally managed, institutional-grade investments.

In addition, the IRS has been known to allow taxpayers to exchange a single relinquished property for one replacement property in a deferred exchange and another in a reverse exchange — as long as the Sec. 1031 guidelines are followed for both exchanges.

Can I Eliminate Capital Gains Tax?

In most cases, like-kind exchanges defer capital gains tax until you sell the replacement property. But, you may be able to eliminate the capital gains tax bill — if you retain the replacement property for life. Then, your heirs will receive a stepped-up basis in the property, which erases any capital gains tax accumulated over your lifetime.

Where Do I Start?

Like-kind exchanges can be complicated, so always consult with a tax professional before signing any documents. Contact our team of corporate tax specialists for more information.