Are you selling real property with plans of buying a new one of the same kind? If so, you may be able to defer capital gains tax through a like-kind exchange that you need to report in your Form 8824.
What is a like-kind exchange?
Taxpayers who exchange real property with the same nature or character in a like-kind transaction may qualify for capital gains tax deferral under Section 1031.
You can only claim a like-kind exchange if the property involved is held solely as an investment or utilized exclusively for business. Properties held for sale will not qualify for a like-kind transaction. Moreover, you can’t recognize gains or losses for this transaction.
Now, what if you receive other properties in addition to the like-kind property?
In this case, you may recognize a gain on the transaction involving that property. However, you may NOT claim a loss from the exchange.
How does a like-kind exchange work?
To show how a like-kind transaction works, here’s an example.
Say you bought an apartment for $200K and then you sold it for $350K. In a normal sale, you would have to pay capital gains tax on $150K ($350 – $200K).
But you can avoid paying capital gains tax on that $150K by entering a like-kind exchange transaction. This can be a viable solution if you have plans to buy a new property of the same kind anyway. By doing this, you can avoid paying capital gains tax on that $150K and defer it until you sell the second property.
In some cases, it may be more practical to do a like-kind exchange again for the second property. When this happens, the gain will, once again, pass on to the new property you exchanged.
What properties qualify in a like-kind exchange?
Like-kind properties should have the same nature or character although the grade or quality may differ. This means that you can swap an apartment for a duplex or a vacant lot for a factory with the land. However, these properties must be within the U.S. soil to qualify under section 1031.
Before 2018, personal and intangible property qualified for a like-kind exchange. However, under the new tax law, only real estate properties qualify for like-kind exchange transactions.
Aside from the nature of the property, you should also beware of like-kind exchange deadlines.
· 45 Days: You only have 45 days to identify a potential replacement property from the date you sell your property. This period also involves notifying the seller or an intermediary of the replacement property of your intention.
· 180 Days: You need to complete the acquisition of the replacement property within 180 days from the date of sale.
If you fail to meet these deadlines, the transaction may be reported as a sale in the current year.
What is Form 8824?
If you report a like-kind exchange, you need to file Form 8824 by the end of the tax year. You also need to attach this form to your income tax return for the year you began to close the replacement property.
What if you did not close the deal until the next year?
In this case, you have to file Form 8824 for the current year until the year you sold the relinquished property.
What should I report in Form 8824?
Form 8824 contains four parts that require the following information.
Part I: This part asks for information about the Like-Kind Exchange transaction. You need to input details about the property that you gave up and the replacement property you received.
Part II: If you entered a like-kind exchange with related parties during the year, you also need to fill out this section. You need to disclose the name of the related party and other relevant details.
Part III: In this section, you need to report gains or losses from the transaction.
Part IV: You only need to fill out this section if you are a federal employee who is required to report conflict-of-interest sales. This part may also apply to spouses and dependents of those employees.
For additional guidance on how to fill out Like-Kind Exchange Form refer to the IRS instruction form for Form 8824.
What happens if I do not file Form 8824?
There are no penalties for failure to file Form 8824 but there are consequences.
For starters, you can’t defer capital gains tax. This means that the exchange may be treated as a sale transaction subject to capital gains tax. Depreciation may also be recaptured, and you may be subject to penalties for not paying capital gains tax.
How do I file Form 8824?
You need to file Form 8824 with your annual tax return.
Form 8824 can be complicated. So, it would be best to seek professional help in accomplishing this form to avoid making mistakes. Don’t forget to plan tax activities for the year to make sure you have all the information you need for your tax return and all its required attachments.
