What could be a more compelling estate tax planning strategy than allowing a lifetime’s worth of appreciation in your property’s value to permanently escape income tax? The answer is found in a combination of the income tax like-kind exchange rules and the stepped-up basis at death rules, both found in the Internal Revenue Code (IRC).

Here is an example of how this strategy works: At age 30, Jason purchases his first investment property, a small apartment building, for $150,000. At age 36, he sells the building for $275,000 and uses the proceeds as a down payment to buy a strip shopping center for $500,000. At age 50, Jason sells the shopping center for $1.3 million and uses the net proceeds to buy an office building for $2.2 million. At age 68, he sells the office building for $4 million and buys two big box retail stores under long-term triple-net leases to credit quality national tenants. Jason dies at age 78 when the buildings are worth $4.4 million. His children inherit the real estate.

If Jason properly structures each sale and purchase under the like-kind exchange rules, he can accomplish each transaction in this example without paying any income tax. And using the stepped-up basis rule, Jason’s children can sell the real estate at $4.4 million, with neither the children nor Jason ever having paid income tax on the $4.25 million of appreciation that has accrued over Jason’s 48 years as a real estate investor.

Another typical situation involves elderly or ailing people who receive an offer on long-held property for a substantial profit. Though the offer may seem like the chance of a lifetime, incurring a large gain and paying a 20% or 25% capital gains tax may be poor tax planning since death in the near future may be likely. Through a like-kind exchange, however, the gain can be deferred and the income tax made to disappear as a result of the stepped-up basis at death.

Requirements

To qualify a sale and purchase as a tax-free exchange, you must identify the new property within 45 days of the date you transfer the old property, and you must close on the new property within 180 days of the transfer date of the old property. Most important, during the time between the sale date and the buy date, you must not have control over the proceeds of the old property sale.

The IRS has established certain safe harbors that allow qualified intermediaries to act as special agents. For a fee, the intermediary will facilitate the sale of the old property, hold the net proceeds of the sale and facilitate the purchase of the new property, all in keeping with the tax-free exchange rules. This also avoids the complication of the buyer of the old property or the seller of the new property having to cooperate in the exchange.

You also must trade up or even, meaning that you must purchase the new property for a price equal to or greater than the selling price of the old property, and in the process use all of the net proceeds of the sale. Trading down in price -- or not using all proceeds of the sale -- creates boot, which will result in at least partial capital gain recognition and taxable income.

In the context of real estate, like-kind has a broad meaning. You can trade an apartment building for a retail shopping center or an office building. You can exchange raw land held for investment for improved property. If you own a manufacturing facility that is leased to your company, you can sell the real estate and use the proceeds to buy a new manufacturing facility or investment real estate. Real estate that is not held for investment or for business use -- such as real estate held by a builder as inventory or purchased with the intent to flip or resell -- will not qualify. Owner-occupied residential property also does not qualify, and you cannot exchange foreign real estate for U.S. real estate.

Estate Tax

The like-kind exchange does not eliminate the estate tax. Indeed, in the example at the beginning of this article, Jason’s children will get a stepped-up basis and escape the income tax on the gain because he dies with the property in his taxable estate.

But there are still ways to implement gifting programs and other estate tax minimization techniques. For example, Jason can refinance his real estate to give himself the cash with which to make annual exclusion gifts to his children or pay his grandchildren’s college tuition gift tax free. Or, Jason can transfer the real estate to a family limited partnership (FLP) and gift limited partnership interests at an attractive discount. Jason remains in control of the real estate (as general partner) with the ability to exchange it tax free for new real estate at the partnership level.

Tough Cases 

The tax-free exchange rules are detailed, and not all sales and purchases will fit the rule. For example, you cannot do a reverse exchange -- which is a purchase of the new property before the old property is sold. Accommodation parties can, however, put reverse exchanges forward by buying and holding the new property until you sell the old property, or buying the old property from you before you buy the new property. Sales in exchange for installment notes present other problems, but accommodation parties can again be used to liquefy installment notes in order to complete an exchange. Interests in real estate partnerships cannot be exchanged, but with proper planning, certain real estate can be held in co-tenancy, which will allow each co-tenant to exchange as he or she pleases, separate from the other owners. Also, real estate to be constructed can qualify as new property in an exchange.

Non-Real-Estate Exchanges

Although most exchanges involve real estate, many other types of property qualify for exchange treatment. For example, businesses that own delivery vehicles can trade for new delivery vehicles and avoid tax on the gain -- even depreciation recapture. The rule applies similarly to certain types of business machinery and equipment. While in a broad sense, one business cannot be exchanged for another business, many of the underlying assets -- other than goodwill -- can be exchanged for similar assets.

Tax Savings, Not Just Deferral

As our example illustrates, effective estate planning can be aided by good income tax planning in a way that turns income tax deferral techniques into permanent tax savings. By merely timing your purchase and sale of investment property to occur within 180 days and refinancing to take out the desired amount of equity, you can  have your cake and eat it too, maximizing both your own use of cash and the after-tax bequests you make to your heirs.

We would be happy to consult with you about ways to take advantage of the complex yet extremely beneficial rules governing like-kind exchanges. Please contact us with any questions you may have about these or other tax-saving strategies.

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