Defer a current tax bill with a like-kind exchange

Asset-for-asset or boot

Under the Tax Cuts and Jobs Act, tax-deferred Section 1031 treatment is no longer allowed for exchanges of personal property — such as equipment and certain personal property building components — that are completed after December 31, 2017. California conforms to this change for most taxpayers for exchanges initiated after January 10, 2019.

If you’re unsure if the property involved in your exchange is eligible for like-kind treatment, please contact us to discuss the matter.

Assuming the exchange qualifies, here’s how the tax rules work. If it’s a straight asset-for-asset exchange, you won’t have to recognize any gain from the exchange. You’ll take the same “basis” (your cost for tax purposes) in the replacement property that you had in the relinquished property. Even if you don’t have to recognize any gain on the exchange, you still must report it with your federal income tax return on Form 8824, “Like-Kind Exchanges.”

However, in many cases, the properties aren’t equal in value, so some cash or other property is added to the deal. This cash or other property is known as “boot.” If boot is involved, you’ll have to recognize your gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you get in the like-kind replacement property you receive is equal to the basis you had in the relinquished property reduced by the amount of boot you received but increased by the amount of any gain recognized.

California Considerations

The rules for like-kind exchanges in California are similar to the federal rules. There are, however, different reporting requirements. If you exchange California property for one or more out-of-state properties and any portion of the realized gain is deferred, you must report the exchange on California Like-Kind Exchanges (FTB 3840).

While you only need to file the Form 8824 with your federal return in the year of the exchange (or for an additional 2 years if it was with a related party), you’ll need to file the FTB 3840 annually for as long as the gain continues to be deferred.

How it works

For example, let’s say you exchange a California business property with a basis of $100,000 for a building located outside of California valued at $120,000, plus $15,000 in cash with an unrelated party. Your realized gain on the exchange is $35,000: You received $135,000 in value for an asset with a basis of $100,000. However, since it’s a like-kind exchange, you only have to recognize $15,000 of your gain. That’s the amount of cash (boot) you received. Your basis in the new building (the replacement property) will be $100,000: your original basis in the relinquished property ($100,000) plus the $15,000 gain recognized, minus the $15,000 boot received.

Note that no matter how much boot is received, you’ll never recognize more than your actual (“realized”) gain on the exchange.

In the year of the exchange, you must file Form 8824 with your federal tax return to show the $20,000 gain deferral. You must also report the exchange on your California return by filing FTB 3840 in the year of the exchange and every subsequent year until the $20,000 gain is no longer being deferred.

If the property you’re exchanging is subject to debt from which you’re being relieved, the amount of the debt is treated as boot. The reason is that if someone takes over your debt, it’s equivalent to the person giving you cash. Of course, if the replacement property is also subject to debt, then you’re only treated as receiving boot to the extent of your “net debt relief” (the amount by which the debt you become free of exceeds the debt you pick up).

Unload one property and replace it with another

Like-kind exchanges can be a great tax-deferred way to dispose of investment, trade or business real property. But you have to make sure to meet all the federal and state requirements. Contact us if you have questions or would like to discuss the strategy further.

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