When an investor sells a property for a profit, the gain on sale is subject to capital gains taxes. To defer taxes on a capital gain, many investors choose to reinvest their sales proceeds in a new like-kind property in a 1031 Exchange. This article by Lilypads focuses on the like-kind property definition in a 1031 exchange.
What is a 1031 Exchange?
A 1031 Exchange is a real estate transaction that allows a real estate investor to defer or eliminate capital gains taxes after the sale of an investment property.
However, the IRS tax code states that the investor must reinvest their sale proceeds in a like-kind property within 180 days of the sale.
Read Lilypads’ article on 1031 exchange rules here.
What is a like-kind property?
The term like-kind property refers to two real estate assets of a similar nature, character, or type regardless of their grade or quality. Thus, the 1031 exchange rules state that any property can be exchanged for another without incurring any tax liability.
The Internal Revenue Code defines a like-kind property as an asset held for investment, trade, or business purposes under Section 1031. Therefore, this implies that both the properties involved in the exchange must be used for business or investment purposes.
Like-kind property is property of the same nature, character, or class. Hence, most real estate will be like-kind within the United States. For instance, vacant land is not similar to office property. But, a multifamily asset is like-kind to an office building.
But, if the property is not exactly “like-kind” then the IRS will tax the full amount of the sale. Hence, it is better to know what does not qualify as a like-kind property and the basic restrictions of qualified like-kind exchanges.
Read Lilypads’ article on the top 10 benefits of the 1031 exchange here.
Like-kind property restrictions:
Real property and personal property can both qualify as like-kind property. But real property can never be like-kind to personal property.
Also, the following property types are not considered like-kind to anything. Therefore, they are specifically excluded from a 1031 tax-deferred Exchanges:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
1031 Exchange like-kind property examples:
To understand the kinds of replacement property in practice there are several examples that cover the scenario that a 1031 real estate investor could encounter.
- Like-kind exchange with boot: In a 1031 Exchange, “boot” is the fair market value of the cash or other property received in a 1031 exchange. Hence, the investment properties received are taxable. For example, a real estate investor sold a piece of land for $100,000. And, they used a shopping center as exchanged property for $800,000. So, the difference of $200,000 is considered “boot”. The capital gains taxes depending on the longevity of the property.
- Like-kind exchange with debt: Generally most commercial properties have some sort of debt. Under the Internal Revenue Service tax code, the value of the relinquished property and the equity in it must be the same as or greater than that of the replacement property. If it isn’t, the difference then becomes boot.
- Reverse exchange: In a reverse exchange, the 1031 Exchange process happens in reverse. Hence, an investor identifies and buys the replacement property first. Then, they sell the relinquished property.
- Partial exchange: In a partial exchange, the entire sale proceeds are not invested into the replacement property. For example, a shopping center was sold for $500,000. But the investor uses only $450,000 for trade or business. Therefore, it is a “partial” exchange and the difference is the boot. And, it is taxable.
Like-kind property examples:
Examples of qualified like-kind properties are:
- Oil and gas royalties for a ranch
- Fee simple interest in real estate for a 30-year leasehold or a tenant-in-common interest in real estate
- Triple Net lease investment properties
- Vacant undeveloped land
- Agricultural or farm properties
- Single-family residential properties
- Multifamily properties
- Commercial office properties
- Industrial warehouse
- Retail shopping properties
- Residential, commercial, industrial, or retail rental properties for any other real estate
- Rental condo for a three-unit apartment building
- Mitigation credits for restoring wetlands for other mitigation credits
- Mineral Rights
- Air Rights
- Water Rights
- Oil and Gas Interests
Non-Like-kind property examples:
Non-like kind properties do not fall qualify for 1031 exchanges. Such properties include:
Personal Use Assets
- Primary residence
- Vacation home
Property held for sale
- A property that is acquired for development and then its sale
- A converted property which is then sold
- Property acquired to fix up and sell
- Property held for sell
- Mutual funds
- Real Estate Investment Trusts (REITs)
Ownership Interest in an Entity
- Partnership interests owned in a general or limited partnership
- Membership interests held in a limited liability company
- Shares of stock owned in a “C” or “S” corporation
Like-kind exchanges with Delaware Statutory Trusts:
One of the major challenges for 1031 Exchangers is finding a suitable replacement property. So, 1031 investors can invest the sales proceeds in a Delaware Statutory Trust or “DST”.
A DST is a specialized company formed specifically for acquiring commercial real estate property. Here, instead of purchasing a replacement property the investors can purchase shares in a DST and use them as the exchange. As a result, real estate investors can have fractional ownership of an institutional quality asset. Furthermore, they also can avail all the benefits of ownership without the hassle of actually managing the property.
In a DST, two parties hold property or run business operations between them. Under this agreement, they can hold, manage, administer, operate, or invest in real estate for the benefit of one or more trustees. Hence, DST investors should work closely with their CPA and investment facilitator. So, they can ensure that they follow all the rules and qualify for full tax deferral.
The Lilypads Bottomline
After going through this blog you get an idea of “like-kind”. But it is ideal 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 avail its advantages then they may find themselves stuck with a hefty tax bill.