IRS to Tighten Enforcement of Like-Kind Exchange Rules

If you are considering a like-kind exchange (also known as a Section 1031 or Starker exchange), you need to review the IRS regulations that apply…and do it right.

Like-kind exchanges allow investors to defer taxes when they dispose of property they currently own and replace it with similar property. However, the Internal Revenue Service plans to increase audits and enforcement of these exchanges beginning mid-2008.

Usually when a business or investment property is sold, the seller must pay tax on any profit. The tax varies depending on the type of income and the current tax rate. For example, if you purchased land for $100,000 and sold it for $200,000, you could expect to owe $15,000 federal income tax on the transaction, assuming a current capital gains tax rate of 15%.

With a like-kind exchange, it is possible to purchase property for $100,000, sell it for $200,000, buy another like-kind property for at least $200,000, and avoid income taxes on that sale. But you have to follow the IRS rules precisely, and this requires planning prior to the transaction.

First, the property sold and the replacement property must be “like-kind.” IRS rules and regulations offer guidance to help determine what qualifies as like-kind property. For example, you can exchange a single-family home for an office building, or an apartment complex for a shopping center. But you can’t exchange your home for an oil well and you can’t exchange real property for a business.

Second, many like-kind exchanges will require the assistance of a qualified intermediary in order to comply with all of the requirements for a tax-free exchange. You can usually find a qualified intermediary in your area by checking the Yellow Page listings under “Title Companies.”

All like-kind exchanges must be reported to IRS by filing Form 8824 with your federal income tax return.

Sounds confusing? Studies by the IRS and the Government Accounting Office have found consumers don’t understand the rules. But help is on the way.

The IRS has updated Publication 17 “Your Federal Income Tax” to better tell taxpayers about like-kind exchanges. Additional information about the like-kind exchange process is found in IRS Publication 544 “Sales and Other Dispositions of Assets,” and in the instructions for Form 8824.

There are significant savings you can realize. But the best advice is to get your accountant involved at every step.

This information is provided as a public service, and should not be construed as individual accounting or tax planning advice. For information on how these general principles apply to your situation, please consult an accounting or tax professional.

Greg Cook, EA, CPA, ATA is an Accredited Tax Advisor whose practice is located in Arab, Alabama.