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 the tax code that offers this benefit.
There are several different types of 1031 exchanges . These include simultaneous 1031 exchanges, which occur when an investor closes on the relinquished property and the replacement on the same day, and deferred 1031 exchanges, which allow 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 .
What is Like-Kind Property?
According to the IRS , the like-kind property is defined as:
However, that is not the whole story. Tax expert, Robert Wood, explains for Forbes :
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.
Like-Kind Property Restrictions
A like-kind property must be an investment property, not a personal one. According to the IRS ,
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:
- Inventory, stock in trade
- Stocks, bonds, and other types of notes
- Securities, debt
- Partnership interests
- Trust certificates
Like-Kind Property, Delaware Statutory Trusts (DSTs) and LLCs
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:
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.