What is a similar exchange?
A similar exchange, sometimes called a similar exchange, is a tax-deferred transaction that allows the sale of an asset and the acquisition of another similar asset without generating a capital gains tax liability from from the sale of the first asset.
Until the adoption of tax legislation in December 2020, this could have included the exchange of one business for another – or of tangible property, such as a work of art or heavy equipment , against another. After 2020, a similar exchange only applies to the exchange of a commercial or real estate investment property for another property.
Key points to remember
- A similar exchange is used when someone wants to sell an asset and acquire a similar one while avoiding capital gains tax.
- Similar exchanges are closely monitored by the IRS and require accurate accounting to ensure that no tax penalty is incurred.
- Savvy sellers can use the same trade to defer other specific types of gains, such as depreciation.
How a similar exchange works
When a commercial building or an investment building is sold for a gain, the investor is required to pay a capital gains tax on the profit made. All capital gains are taxed either at the short-term capital gains rate of between 10% and 37% for profits made on a sale within one year, or at the long-term rate of between 10 % and 20% for profits made on a sale after one year from the date of initial purchase.
A similar type of exchange is also called a 1031 exchange or a Starker exchange.
However, article 1031 of the Internal Revenue Code (IRC) exempts an investor from making a tax payment on a gain if the proceeds from the sale or disposal of the property are reinvested in similar property of equal value. or higher as part of an exchange of the same kind. All real estate, with the exception of his own personal residence, is considered to be similar to any other real estate. As a general rule, any property held for productive purposes in trade or business or for investment purposes is eligible for an exchange of the same kind.
A taxpayer who sells an investment property and purchases another within a prescribed time will not have to pay tax on the first transfer. They will have to pay the tax when the second property is sold or disposed of, unless another similar exchange is made, in which case the payment of the tax will be deferred again.
There are several important considerations to keep in mind with a similar exchange to ensure that a tax liability is not created when the first asset is sold:
- The assets sold must be an investment property and cannot be a personal residence.
- The asset purchased with the product must be similar to the asset sold.
- The proceeds of the sale must be used to buy the other asset within 180 days of the sale of the first asset, but you must identify the good or asset that you purchase in the exchange of the same kind within 45 days the sale.
There are certain limits to the amount of capital gain that is tax-deferred, so be sure to check the latest tax rules before making a similar exchange.
In addition to the tax deferral benefits, a similar exchange allows the seller to defer their depreciation recapture – the gain from the sale of depreciable capital property which must be reported as income for income tax purposes. returned. A taxpayer can also avoid state taxes on similar exchanges.
For example, some states require a buyer or seller to pay income taxes when a property is sold, known as state withholding. Goods transferred within the framework of an exchange of the same kind may, however, benefit from an exemption. To claim the exemption, the taxpayer will have to sign an exemption form or a certificate provided by the state. Some states require the seller to submit the exemption 20 days before closing, while other states may allow the exemption form to be submitted at closing.
Real example of an exchange of similar type
A similar exchange is ideal for a business owner looking to sell his business and invest in another or a real estate investor who wants to sell a rental property and buy a similar one. A Form 8824 must be filed with the Internal Revenue Service (IRS) detailing the terms of the agreement. Recognized gain because the start-up – cash, liabilities or other goods that are not of the same kind and which are given or received in an exchange of the same kind – has been received is declared on form 8949, appendix D (form 1040) or 4797, as in force. If depreciation is to be recovered, this recognized gain may have to be reported as ordinary income.