To Exchange, or Not to Exchange: That Is the Question?

Erin Horman, CPA, Tax Senior Manager   email
October 2009

The deferral of income taxes is an advantage available when sellers exchange similar properties that are held for income, investment or business purposes. This exchange is known as a like-kind exchange. There are many requirements that must be satisfied in order to conduct a like-kind-exchange. Sellers tend overlook the option of an outright sale because they often only focus on income tax deferral as a qualifying exchange. Sellers must decide before the sale if they are planning to carry out a like-kind exchange or not. Below are some issues to evaluate when considering a like-kind exchange:

Sell Losses.

The general rule of thumb is: to trade gains and sell losses. Additional work and costs are involved in a like-kind exchange and as such a preliminary calculation of the gain or loss on the sale should be done before any other steps are taken. Like-kind exchange rules apply to both gains and losses, and thus if the disposal translates into a loss (or a small gain) the additional professional expense is not worth it.

Passive Losses Allowed.

Income producing property may have carryover passive activity losses that were disallowed in prior years. When property is disposed of in an outright sale (and, not in a like-kind exchange), the carryover passive losses are allowed, triggering an ordinary loss deduction. If that same property instead is part of a like-kind exchange, the passive losses continue to carryover with the replacement property, and are only allowed to the extent of passive income, or a taxable sale of the replacement property.

Future Tax Rates.

Deferring gains for a short period of time may not be worth the additional professional fees if a subsequent disposal of the replacement property is not also rolled over. Project possible future tax rates to determine if deferring is beneficial. Deferring a long-term capital gain that is currently taxed at 15 percent for federal purposes and 5.4 percent for Wisconsin purposes could increase in a few years. For federal purposes, the 15 percent long-term capital gains rates are set to expire at the end of 2010 at which time the tax rate will revert back to 20 percent. Further, any ordinary income associated with the sale, will also likely be taxed at a higher rate as income tax rates for federal and Wisconsin purposes will rise over the next few years.

Available Capital Losses.

Finally, consider any capital loss carryovers in your analysis. Many taxpayers have incurred significant capital losses in the past year which may offset part or all recognized capital gain from a property sale.

A like-kind exchange is a useful tool to defer taxes; just be sure to evaluate all aspects before incurring the time and expense of doing one.