The Definition of Like-Kind Property in a 1031 Exchange
Real estate investors who sell a property can sometimes take advantage of a section in the U.S. IRS’ tax code that allows them to defer capital gains or losses on the property. This is called a 1031 exchange, after the section of tax code that offers this benefit.
There are several different types of 1031 exchanges. These include simultaneous 1031 exchanges, which occurs when an investor closes on the relinquished property and the replacement on the same day, and deferred 1031 exchanges, which allows an investor up to 180 days after the sale of a property to complete the exchange.
No matter the timeline, the property exchanged must be what the IRS calls “like-kind.” This article will help better define a like-kind property for any 1031 exchange.
According to the IRS, like-kind property is defined as:
“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. Also, improvements that are conveyed without land are not of like kind to land.”
However, that is not the whole story. Tax expert, Robert Wood, explains for Forbes:
“Exchanges must merely be of ‘like-kind’— an enigmatic phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But again, there are traps for the unwary.”
This can be problematic. If a property is not actually “like-kind”, the IRS will tax the full amount of the sale but an investor may not find out until they file forms to claim the 1031 exchange tax advantage. Therefore, it helps to understand some basic restrictions on 1031 exchanges before proceeding.
A like-kind property must be an investment property, not a personal one. According to the IRS,
“Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.”
Property does not qualify as like-kind if one property is in the U.S. and another is outside of it. Additionally, an investor may be able to exchange a property for a stake in a Delaware Statutory Trust (DST) under certain circumstances, given changes in the tax code.
Like-kind property does not include the following:
There are several limited partnership structures including DSTs, limited liability companies (LLCs) and tenants in common (TIC) partnerships. However, the only one that qualifies for potentially special treatment under a 1031 exchange of like-kind property is the DST.
In a DST, two parties hold property or run business operations between them. Under this agreement, real estate can be held, managed, administered, invested in or operated for the benefit of one or more trustees.
According to law firm Richards Layton & Finger:
“Delaware Statutory Trusts are used as vehicles for investment, as legal entities for the conduct of business, and as special purpose entities for the holding of title to assets. The flexibility of the Act as to the operation, management and activities of the trust and the limited liability granted to beneficial owners have made Delaware Statutory Trusts the perfect vehicle for a diverse range of business transactions.”
In 2004, the U.S. Internal Revenue Service delivered a ruling that affected how DSTs apply to 1031 exchanges. On a case-by-case basis, you may exchange a property under a 1031 exchange for an interest in a DST. That means you can perform the exchange of property for an interest in a DST without registering a capital loss or gain under a 1031 exchange.
Given the various interpretations of the definition of “like-kind,” it is recommended to involve a qualified intermediary when attempting a 1031 exchange. The benefits of such an exchange could be powerful, but if an investor unknowingly tries to exchange properties that are not defined by the IRS as like-kind, they may find themselves stuck with a hefty tax bill.
If you have a property you are interested in exchanging, you can register here to get started.