A like-kind exchange occurs when an investment property or business is exchanged for a similar (or like kind) property or business. Internal Revenue Code section 1031 allows one to avoid recognizing any gain or loss on the exchange transaction. The basic rule of this type of exchange is:
- The assets must be of a similar nature; and
- The owner must use both the original and replacement assets for the same purpose
If a different type of property or a cash payment is made as part of an exchange, then the value of these unrelated items are to be recognized as a taxable gain. However, any portion of the transaction for which there was a like-kind exchange still qualifies under the like-kind exchange rule.
Several other points regarding like-kind exchanges are:
- It cannot be applied to an exchange of securities, partnership interests, or inventory.
- It cannot be applied to the exchange of real property where the outgoing property is located within the United States and the replacement property is located outside of the country.
It is allowable to have a deferred exchange of assets that still qualifies as a like-kind exchange. This "Starker" transaction (also known as a 1031 tax deferred exchange) only applies if the replacement property has been identified within 45 days of the asset transfer date and:
- The earlier of the date when the replacement property is received; or
- The due date of the tax return for the tax year in which the transfer initially took place.
During this interim period, a third party retains the cash or other proceeds from the disposition of the first property in an escrow account, and then acquires the replacement property on behalf of the seller and shifts ownership of that property to the seller.