Like-Kind Exchanges: Deferral Is Not Always the Best Option

Why waiting to pay a tax is not always the right strategy.

April 2009
by Claire Y. Nash and James Parker/The Tax Adviser

When taxpayers sell real estate and replace it with like-kind property, Sec. 1031 gives them the opportunity to defer taxation on the gains they may have on their transactions. Anytime there is an opportunity to defer tax costs, tax practitioners and their clients automatically tend to assume that they should take advantage of the opportunity. However, in the case of like-kind exchanges, it is not always in the taxpayer’s best interest to elect to defer the recognition of gain on realty.

In order to qualify for a like-kind exchange on realty, taxpayers usually must engage the services of an intermediary at the cost of an agency fee, and they are under a relatively stringent time constraint for finding a replacement property. Moreover, deferral of tax on the gain results in a limited basis in the qualified replacement property, which, in turn, limits the amount of depreciation deductions available to the taxpayer on the qualified replacement property over its cost recovery period.

When the tax rates on a taxpayer’s gain from the sale of realty are substantially lower than the marginal tax rate on the ordinary income that he or she could shelter with depreciation deductions on newly acquired property, the taxpayer may be better off forgoing deferral of tax on the gain. In such instances, the taxpayer would have a higher depreciable basis in the acquired property and thereby have a larger net tax savings over time from the higher depreciation deductions.

This article has been excerpted from the The Tax Adviser. Read the full article here (PDF).