This blog post was written by George Ratiu, Director of Quantitative & Commercial Research and Erin Fitzpatrick, Research Intern.
Like-kind exchanges (LKE) provide an important vehicle to sell and acquire property—both real and personal. A key feature of LKEs consists of allowing a property owner to dispose of a property and acquire another one of like-kind, with any gain after the disposition deferrable as long as the proceeds are reinvested in a similar property. The Internal Revenue Service (IRS) makes note of the fact that while the gain “is tax-deferred […] it is not tax-free.” At some point, the property owner disposes of the property and gains are recognized, leading to tax payments.
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.
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.
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 and be flexible in the face of changing economic and market conditions. Another main benefit is that LKE transactions lead to commerce and economic growth. Generally, LKEs involve additional investments in improving properties—especially for real estate—which generate jobs.
The Like-Kind Exchanges: Real Estate Market Perspectives 2015 report illustrates that like-kind exchange 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.
 Internal Revenue Service, Like-Kind Exchanges Under IRC Code Section 1031, FS-2008-18, February 2008