For a significant proportion of real estate market participants, like-kind exchanges (LKE) provide an important vehicle to sell and acquire property. LKEs allow a property owner to dispose of a property and acquire another one of like-kind. The Internal Revenue Code (IRC) Section 1031 codifies that the tax owed on any gain after a sale may be deferred as long as the proceeds are reinvested in a similar property through a LKE. The Internal Revenue Service (IRS) makes note of the fact that while the gain “is tax-deferred […], it is not tax-free.” 1 At some point, the property owner disposes of the property and gains are recognized, leading to tax payments.

From a historical perspective, LKEs were recognized in tax law going back to the Revenue Act of 1921. The underpinning principle of the law was the fact that a taxpayer’s economic position did not change as a result of an exchange of property for another of like-kind. With no change in economic position, there was no need to recognize or impose a tax on the transaction. Any gain from the transaction was deferred. This principle is important as it recognizes that LKEs are a tax-neutral feature of the law, which does not result in a loss of tax revenue.

The main requirement of a LKE is that the disposition of one property and acquisition of another property must be part of an integrated transaction, rather than two individual transactions. In addition, while both real and personal property qualify, the properties must be similar, pursuant to specific criteria which delineate eligibility. An important aspect of this process is the cost basis of the original property. The basis is carried forward to any and all subsequent properties. The property owner does not have the ability to depreciate a newly acquired property at the higher exchange value, but retains the disposed property’s original cost.

According to the IRS, “like-kind property is property of the same nature, character or class. […] Most real estate will be like-kind to other real estate.” 2 Generally, a parcel of land with a rental house may be exchanged for vacant land. Similarly, an office building may be exchanged for an industrial warehouse or a retail shopping center. The IRS makes exception with real properties located outside the United States, noting that domestic U.S. real estate may not be treated as like-kind to international real estate.

Like-kind exchanges provide several major benefits. The main one is the freer flow of capital. LKE transactions allow property owners to allocate capital more efficiently to be flexible in the face of changing economic and market conditions. Another main benefit is that LKE transactions lead to commerce—as they involve multiple parties—as well as economic growth through job creation. Generally, LKEs involve additional investments in improving properties—especially for real estate—which shorter-term generate construction jobs, but also longer-term employment opportunities for property managers, leasing agents, maintenance staff etc.

The NAR Like-Kind Exchanges: Real Estate Market Perspectives 2015 report provides a real estate perspective on the issue, based on a national survey of NAR members. The report indicates that LKEs are important to small businesses and small business owners. Based on the data, close to half of LKE transactions occurred between small investors—the survey results show that 48 percent of the total fair market value of exchanged properties was held in an individual or sole proprietorship.

Like-kind exchanges also featured prominently in NAR members’ real estate transactions. Based on the data, slightly over 60 percent of respondents indicated that they participated in at least one LKE over 2011-2014.

Just as importantly, the report illustrates that LKE transactions facilitated additional capital into the local market. When asked if they or their clients invested additional capital in order to make improvements after acquiring real property, a majority of REALTORS®—86 percent—answered affirmatively.

Moreover, 56 percent of respondents indicated that they or their clients made property improvements in the 10 – 24 percent range of the acquired property’s fair market value. Commercial practitioners pointed to the fact that these additional investments are generally responsible for the creation of new jobs, such as construction and property management.

Based on responses, 40 percent indicated that transactions would not have happened at all during 2011-2014 without the availability of LKEs. Another 24 percent reported that about 75 – 99 percent of their transactions would not have occurred, and 18 percent of members marked that 50 – 74 percent of transactions over a four-year period would not have occurred absent the tax-deferral option. This is a clear answer to any question about the potential impact upon real estate transactions in the absence of the tax deferral provision of IRC Section 1031.

To read the entire Like-Kind Exchanges: Real Estate Market Perspectives 2015 report, visit www.nar.realtor/reports/like-kind-exchange-survey.

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