Trade-Ins, Swaps, and Like-Kind Exchanges

By Mark E. Battersby / Published March 2017

 

One area overlooked by lawmakers and the President amongst the talk about changes, repeal, or reform is also overlooked by many pressure cleaning business owners and managers—deferring taxes with swaps, exchanges, and trade-ins. So-called “like-kind” exchanges involve swapping or trading one asset for another without receiving strictly cash on the transaction—or a large, immediate tax bill.

Regardless of whether it is business or investment property being sold or disposed of, wherever there is a gain, tax on that gain must usually be paid at the time of that event. Fortunately, the tax rules allow a pressure cleaning operation to postpone paying tax on the gain if the proceeds are reinvested in similar property in a like-kind exchange. Remember, however, gain in a like-kind exchange is only “deferred,” not tax-free.

Exchanges can include like-kind property exclusively or can include like-kind property along with cash or even property that is not of a like-kind.  If cash or property that is not like-kind is received as part of that transaction, it may trigger some taxable gain. Obviously, these transactions and the rules that govern them are far from easy to understand or to qualify under. 

Like-Kind Exchange Basics

Most exchanges must merely be of a “like-kind”—a phrase that doesn’t always mean what many think it does. A qualifying exchange can involve an apartment building exchanged for raw land, or a ranch swapped for a strip mall, or trucks traded in exchange for a newer truck. Under the surprisingly liberal rules, one business can even be exchanged for another but, again, there are traps for the unwary.

First, both the property given up and the property received must have been held for investment or for productive use in a trade or business. Vehicles, equipment, machinery, buildings, etc. used in a business all qualify.

The second basic requirement is obvious: the property exchanged must be of “like-kind.” One example is a truck for a truck. With real estate, the most popular type of like-kind exchange, almost any ownership interest in real property exchanged for another interest in real property will qualify. For example, exchanging raw land in a rural area for a rental apartment building in the city qualifies.

The Calendar Strategies

Under the tax rules, a pressure cleaner has 45 days from the date the property is relinquished to identify a new property and 180 days (from when the property is relinquished) to close on the replacement property. Both deadlines are firm.

The first deadline is usually the tightest, but it can be manipulated by delaying the transfer of the old property. That will also create more time to close on the replacement property. Taking into account possible delays can help, but remember, it’s not unusual to receive an unsolicited offer that you can’t refuse and have to find a replacement property quickly.

Deferred Exchanges

Many pressure cleaners have discovered that finding another party for an exchange is difficult. That’s especially true with real estate. Fortunately, there’s an option: using a qualified exchange intermediary and a deferred exchange.

A deferred exchange is an exchange in which a pressure washing business transfers qualifying property and later receives replacement property. If payment is received for the property being relinquished, it makes the transaction taxable. Instead, an intermediary is found to hold the proceeds from the sale of the relinquished property and to use that amount to purchase the replacement property. Obviously, to avoid a transaction that is even partially taxable, care must be exercised to ensure that no money or “unlike property” is received.

In a deferred exchange, identifying the property to be received must occur within 45 days after the date of transfer for the property given up in the exchange (the identification period). Any property received during the identification period is considered to be identified. If multiple properties are transferred at different times, the identification period begins on the date of the earliest transfer.

Trade-Ins

Trade-ins are among the most common types of like-kind exchanges. The same basic rules apply, but the time restraints are rarely an issue. For example, the pressure cleaning business goes to their local dealer to replace a truck. It’s unlikely anyone would relinquish their truck only to wait more than 180 days for a new one. 

Thanks to a unique twist, a pressure cleaning operation’s vehicle or equipment trade-in is more likely to have a loss on the property than with real estate. Or, the pressure cleaner may want to have a higher basis or book value in the property for depreciation, the Section 179 first-year expensing write-off for bonus depreciation purposes.

Although there are any number of reasons for recognizing gain from a sale, a good rule of thumb is to always trade “across” or up. Never trade down (the “even or up rule”). Trading down always results in boot received, either cash, debt reduction, or both.  But, what is “boot”?

Boot: Like and Unlike Property

When cash or unlike property (often referred to as “boot”) plays a role in a Section 1031 transaction, or there’s an assumption of liabilities by one or both parties, these exchanges get a little trickier. The term “boot” is not used in the tax law or regulations, but often affects the consequences of Section 1031 tax-deferred exchanges. Boot received is the money or the fair market value of any “other property” that might be received by a pressure cleaning business in an exchange. 

The term “money” includes all cash equivalents, plus liabilities of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject to. “Other property” includes everything non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or “non-qualified property.” Other property also includes such things as a promissory note received from a buyer (seller financing).

Depreciation Computations

Generally, in a like-kind exchange the carryover basis of replacement property is depreciated using the same life and convention and over the same remaining period as the property relinquished. Any additional basis is depreciated using the appropriate life and convention that would apply to the new property.

Special rules apply if the tax lives of the relinquished and replacement properties are different. That occurs most frequently when there’s an exchange of real estate where a commercial property (life of 39 years) is exchanged for a residential property (life of 27.5 years).

Similar rules apply with deferred like-kind exchanges. Generally, depreciation cannot be taken during the period after the disposition of the relinquished property and before the acquisition of the replacement property. Special rules also apply to autos and trucks subject to the write-off caps and depreciation limitations.

Other Nontaxable Exchanges

While not defined as “like-kind” exchanges, there are several other transactions that are often nontaxable:

• The contribution of property to a corporation or partnership in exchange for an interest in the corporation or partnership.
• A merger (technically a reorganization) where shares in the incorporated pressure cleaning business are exchanged for shares in another corporation.
• Replacing property destroyed in a casualty or condemned by the town, county, etc.
• The exchange of insurance policies or annuities for other insurance policies or annuities.

Related Parties’ No-Nos

While a like-kind exchange can be carried out with a related party (family member, subsidiary, shareholder), special rules apply and affect both direct and indirect exchanges. If either party disposes of the property within two years after the exchange, the exchange is disqualified from nonrecognition treatment. The gain or loss on the original exchange must be recognized as of the date of the later disposition. Dispositions due to the death of either related person is an exception, as is a so-called “involuntary” conversion.

To Defer or Not To Defer

Although it might sound as if it always makes sense to do a like-kind exchange, that’s not necessarily true. There are times when realizing gain can be the smarter move.

With a like-kind exchange, depreciation deductions may be lost. Because of adjustments to the basis or book value of the property (reduced for depreciation already claimed) plus any cash added by either party, the tax bill could be impacted. Multiple like-kind exchanges could leave the pressure cleaning operation with a big gain if it sells and doesn’t defer. 

On the other hand, depreciation deductions spread over a number of years might be preferable to paying tax on a substantial gain. Of course, the death of an owner while holding the property means escaping income tax and leaving any heirs a step-up in basis.

Generally, it makes sense to defer the gain. But, a pressure cleaning operation might want to ignore deferral if it has suffered a big capital loss that would otherwise go unused (even in the future), or it’s having a bad year and expects little or no income or even a loss. Seeking professional advice and help working through the numbers is always a good idea, especially with like-kind exchanges, trade-ins, and swaps.