Construction Accounting Article -
Tax Tips for Contractors

Target Audience: Revenue Code Section 1031 Interest, Contractors, Construction Accounting Interest, Property Exchange Interest

Like-kind exchanges offer big savings (but complex rules)

When you’re ready to trade in a piece of heavy equipment for a newer model, don’t just sell it outright or arrange a trade-in with your local dealer. Instead, consider using a like-kind exchange to defer gain without decreasing your basis for depreciation.

Under Internal Revenue Code Section 1031, you can swap unwanted property for property of the same nature — and defer gain until you ultimately sell something outright. Although the rules governing like-kind exchanges are complex, they offer the potential for big tax savings.

Abide by the requirements

All like-kind exchanges must meet these general requirements:

• The properties exchanged must be like-kind (real estate for real estate or equipment for equipment, for example).
• There must be an actual exchange, rather than a sale (though cash can change hands).
  
• The properties must be used in business or held for investment, but can’t be inventory.
• The exchange must be completed within specified timeframes, as explained below.

Like-kind exchanges can involve more than two parties and are allowed for both real and personal property as long as the property is business-related. The property doesn’t even have to exist at the time of the exchange — as could be the case in real estate or construction exchanges.

Know your limits

You have less wiggle room on the timing, however. You aren’t required to exchange property simultaneously, but there are strict timeframes for completion of the trade.

The first is that you must identify the property you’ll receive within 45 days after you close on the property you’re trading. Thus, if you’re trading your office building for newer, more convenient facilities, you have 45 days to designate in writing where your new quarters will be.

This provision was enacted in the aftermath of the Starker case of the 1970s, in which property was relinquished in exchange for property that was to be identified within five years. The court concluded that like-kind exchanges don’t have to be simultaneous, but legislators acted to put limits on their durations.

The second timing requirement for delayed exchanges involves your receipt of your chosen replacement property. Replacement property must be in your possession either within 180 days after you transfer your original property or by the time the relinquishing party’s tax return is due for the taxable year — whichever is earlier.

If you receive the property 160 days after the transfer date, for example, but five days after the relinquishing party’s taxes were due, you can’t consider the transaction a like-kind exchange. If it’s impossible to complete the exchange before the tax due date, the relinquishing party can request an automatic extension. But you still can’t go beyond 180 days in finishing the exchange.

Mind the “boot”

In some cases, you may have to include some non-like-kind property in a like-kind exchange. For example, say you want to get a new pickup truck. You can pay the dealer some cash for a new one without losing the tax benefits of the like-kind exchange.

To do so, however, rather than trading your truck in on a new model, you’d have to sell your old truck to the dealer for its trade-in value and then buy your new truck from the same dealer. Because the sale and purchase are reciprocal and mutually dependent, you can treat the transaction as a like-kind exchange.

In such cases, the cash is called “boot,” and the recipient must recognize it as gain. Similarly, if any property you receive has assets (such as fixtures and equipment) that the property you trade doesn’t have, you may have to recognize gain on those assets.

Get some help

Undertaken properly, a like-kind exchange can save you substantial tax dollars. But, as you can probably tell, the rules governing these arrangements are detailed and complicated. To avoid ugly surprises, discuss any potential exchange with your CPA before you enter into the transaction. Also consider involving a qualified intermediary in some exchanges.

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