Tax Consequences of Barter Agreements

"I'll do your family's dental work for free if you build a deck onto my house." If you're in the construction industry, you've probably received an offer like this or made a similar offer to someone else in a different line of business. It's a modern variation of the age-old practice of barter. What makes it especially intriguing in this day and age is the idea that you can exchange services or products with someone without exchanging money.

Keep in mind, however, that there are tax consequences and the IRS often inquires about bartering when it conducts audits. Under the law, a barter transaction is generally subject to income tax even if the trade is relatively even. Each business must pay Uncle Sam based on the fair market value of the service or product received.

One exception: A transaction that qualifies as a "like-kind" exchange — for example, a trade of one commercial building for another.

Going back to the previous example, let's say that you would normally charge $25,000 to build your dentist's deck and your family receives dental care that would have cost you $22,000 out of pocket. The law requires you to pay tax on the $25,000 as if you had actually received it.

Suppose you receive a promissory note from another business in exchange for your services. If the note is merely security for future payment of income, you don't have to report the income until you start receiving it. However, if the note is a negotiable instrument, you must report the fair market value of the note in the year the note is received.

Keep in mind: If you trade your product or service for a deductible product or service, then you have both taxable income and a tax deduction. The two items offset each other but both must be reported on your return. Ask your tax advisor for more information.