You have decided to expand your operations by moving to a new and better facility. However, the value of your current facility has appreciated greatly during the time you have been there, and you have been claiming depreciation on the improvements for all of those years. Consequently, you will realize a significant gain if you sell the facility, and become obligated to pay a significant tax.
In this situation, there is no reason to sell the old property, pay a tax, and buy the replacement property with the after-tax dollars. Instead, Section 1031 of the Internal Revenue Code allows you to exchange your property for "like-kind" property without recognizing the gain on the old property.
Under Section 1031, subject to certain exceptions, like-kind properties are properties of the same nature or character that have been held for use in a trade or business or for investment at the time the exchange is made. Property acquired solely to participate in an exchange will not qualify as like-kind (i.e., the property must have been, and continue to be, "held" for use in a trade or business or for investment). Unfortunately, neither the Internal Revenue Code nor the Regulations specify the length of the holding period.
If only like-kind property is exchanged, no gain is recognized on your old property, and the replacement property takes on the basis of the old property. However, money or other property—termed "boot"— also received in the exchange may result in taxable gain to the extent of the boot received. Released liabilities also count as boot, so exchanging the mortgage along with the old property may cause gain recognition unless equal or greater debt is assumed along with the replacement property.
Although many people are familiar with like-kind exchanges, many do not know that like-kind exchange treatment is available in a broad range of transactions that bear little resemblance to an exchange of two properties. For example, a person can transfer his or her property before being ready to receive the replacement property or even before identifying the replacement property. This so-called, "deferred exchange" will be tax-free so long as the replacement property (or properties) is identified within 45 days and actually received within 180 days from the transfer of the old property. In deferred exchanges, a "qualified intermediary" (often a title company) is typically hired to hold the property under an exchange agreement.
Deferred exchanges can also be structured in reverse, where the replacement property is purchased before the owner disposes of his old property. This can be done either of two ways. In a "front leg" reverse exchange, the owner loans the intermediary the funds with which to buy the replacement property. The intermediary then exchanges the replacement property for the old property and gives a promissory note to the owner for the loan amount secured by a mortgage on the old property. The intermediary holds the old property until the owner finds someone to buy it, at which time the intermediary uses sale proceeds to pay off the promissory note. In the other version of the reverse exchange, a "back leg" reverse exchange, the intermediary buys and holds the replacement property, and secures the promissory note with a mortgage on the replacement property, instead of the old property.
Another variation on the deferred exchange is the "build-to-suit deferred exchange," under which the owner sells the old property, and only later locates, has built-to-suit, and buys the replacement property. This works like the deferred exchange, but has the additional element of the intermediary's using the proceeds from the sale of the old property, and sometimes a construction loan, to buy the replacement property and renovate the existing facility on the property or build a new facility. If the seller of the replacement property is willing to facilitate the renovation or construction, it may do so by contracting for the renovation or construction, and paying for it with financing arranged by you.
Because the seller of the replacement property may be reluctant to permit renovation or construction before the sale is closed, often the intermediary or the construction company hired to do the renovation or construction will be asked to close the purchase and take title to the replacement property so that it may then perform the renovation or construction. It then proceeds to contract for or perform the renovation or construction. Once it is complete, or the value of the land and improvements made equals the sale price of the old property, it transfers the replacement property in order to complete the exchange.
As you can see, these types of transactions can be somewhat complicated, but the rewards can be significant. Money that would have been paid in taxes can instead be reinvested in your business. Keep in mind that, because of the intricacies of the rules governing like-kind exchanges, you should consult with legal and tax professionals before entering into these types of transactions.
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Because each situation is different, this information is intended for general information purposes only and is not intended to provide legal advice.