A 1031 exchange can only be performed with like-kind property – but what does that mean, and what kinds of properties qualify?
For more than 100 years, property owners have been able to build wealth for retirement by taking advantage of Internal Revenue Code Section 1031, which allows for the deferral of capital gains and other taxes on the sale of business or investment property that is exchanged for a property “of like kind.”
But how can you know if the properties you wish to exchange are “like-kind?” What if one is a farm and another is a residential property? What if one is an apartment building and the other a warehouse? Here’s how the IRS defines “like-kind” and what it means for those interested in pursuing a 1031 exchange.
How Section 1031 defines “like-kind”
IRC Section 1031 states, “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
The IRS clarifies the definition of like kind in more detail on its website:
Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States.
The good news is that “most real estate will be like-kind to other real estate.” This loose definition grants flexibility for exchangers: a 1031 exchange can be performed between many different types of business or investment property and still qualify. Single-family residences, multifamily apartment buildings, commercial office or retail space, farmland, warehouses, and other properties are considered like-kind with each other. You can perform a 1031 exchange with multiple properties, a leasehold with 30 or more years, a conservation easement, or even an interest in a Delaware Statutory Trust (or multiple DSTs). However, there are important exceptions and details that must not be overlooked.
What kinds of properties qualify for 1031? What kinds of properties don’t?
An important element of Section 1031 is that it only applies to real property. Prior to 2018, other types of business property could be used in like-kind exchanges, but changes to the law disallowed personal property exchanges. As such, 1031 exchanges are not allowed for aircraft, automobiles, stocks and bonds, patents, or intellectual property – only “real property” like real estate is acceptable.
Another key component is that the exchanged properties must be held “for productive use in a trade or business, or for investment,” and not “primarily for sale.” If you purchase undeveloped land with the intent to develop it and then sell, it will not qualify because it is being held primarily for sale and not for business or investment. However, land that you develop and then hold as an investment could qualify, but only in certain circumstances.
Because only properties used for business or investment qualify, this means a taxpayer’s primary home cannot be used. For your residence, there is another part of the tax code called Section 121.
Section 121 can sometimes be used in conjunction with Section 1031: a 121 property can become a 1031 property and vice-versa, and it is possible for a vacation home to qualify, though only under specific circumstances. You can also utilize both 121 and 1031 if you own a duplex, live in one unit, and rent out other, but these cases must be navigated properly.
How can I be sure my property will qualify as like-kind under Section 1031?
If you have a complex situation and aren’t sure whether the properties you want to exchange will qualify as like-kind, it’s important to get the right advice. Consult with your tax and legal advisers to determine if a 1031 exchange is right for you. The Internal Revenue Code has a lot of complex rules, far more than we can cover in a blog, and even though the IRS has been generous with the definition of like kind for business and investment properties, the specifics of your individual situation will determine whether you qualify.
One thing you must have to perform a Section 1031 like-kind exchange is a Qualified Intermediary (QI) to hold funds during the exchange. As the nation’s most trusted 1031 exchange accommodator, JTC has experience as a QI for many types of 1031 exchanges, including complex scenarios like reverse exchanges that other service providers may not be familiar with. When it’s time to pursue your exchange, work with a QI that has experience facilitating successful exchanges so you can set yourself on the path to success.
To learn more about JTC’s 1031 exchange services, click here.
