Investors that want to defer paying capital gains taxes use a 1031 like-kind exchange. The replacement property in a 1031 Exchange must be of the same kind of property sold. You also must hold both properties for business, productive use in a trade, or investment (26 U.S.C. § 1031(a)).
A replacement property is “like-kind” to a similar relinquished property. Like-kind properties are not required to be the exact same – so how similar do properties have to be so that they are considered like-kind. Typically, real estate assets are considered “like-kind” as long as both properties are used for business, trade, or investment. Further, all these property types can even count as like-kind to fractional ownership interests in Delaware statutory trusts (learn more about DST shares).
Do properties have to be of the same quality to be “like-kind”?
The I.R.S. states that “quality or grade doesn’t matter. Most real estate will be like-kind to others.” For example, real property that is improved with a residential rental house is like-kind to vacant land (FS 2008-18). Quality is the value of the property despite how it is measured. Properties can differ in market value, square footage, age, and whether they are improved or not. Regardless of how they differ, two properties can still count as like-kind
Do properties have to be located in the same place to be “like-kind”?
Replacement property does not have to be in the same state jurisdiction as relinquished property. But national borders matter. Property within the United States may be exchanged for other U.S. property. Property outside the United States may be exchanged for other property outside the U.S.
Do properties have to be in the same asset class to be “like-kind”?
Replacement properties are not required to be in the same class as relinquished property. Commercial, residential, undeveloped, and developed property are all like-kind to each other, and each is exchangeable.
Do properties have to be held with the same property rights to be “like-kind”?
Property rights are not the same with all real estate ownership. Properties hold either permanent or temporary rights to the land, improvements, or both. Also, properties don’t have to hold the same rights to be deemed like-kind.
However, there are some restrictions:
- Property accommodated with permanent rights to the land and its improvements is like-kind to property held with permanent rights to the land but not the improvements. Either property may be like-kind to property held with rights to the developments and temporary rights to the ground lease if there are more than 30 years left in the term, including renewal plans.
- Leasehold interests that are shorter terms can qualify as like-kind to one another, but not to property held long-term.
- Buildings or additional developments held without any rights to their land are not like-kind to any property.
Do rental properties count as like-kind for 1031 exchanges?
Rental properties, condominiums, and apartments are like-kind and eligible for 1031 exchanges. These property types are like-kind for the following reasons:
- Income is generated through lease and rental agreements.
- This property is not owned for personal use.
Different parts of the property are treated differently if the property owners live at the relinquished rental property. The portion of the property that is available for lease is considered like-kind, and the part that is being occupied by the owner is not. The residential part may qualify for capital gains tax assistance under the Taxpayer Relief Act Of 1997
What does NOT Qualify as Like-Kind Property?
We understand what it takes to be like-kind and that it is relatively broad. The next portion details what restrictions qualify as like-kind property.
What does it mean to be held for productive use in a trade, business, or investment?
According to the I.R.S., a property must be “held for productive use in a trade, business, or for investment”, to be classified as like-kind. This holds for both your relinquished property and the replacement property.
This means that you must own and manage both properties for one of the following purposes:
- To increase capital and appreciating value
- To house one or more businesses
- To create revenue through the lease or rental of the space and its facilities
A primary residence, secondary home, or vacation property does not qualify as investment or business property. Likewise for properties “held for resale”.
Can you do a 1031 exchange on personal property?
This is no longer allowed. Prior to the Tax Cuts and Jobs Act of 2017, property that is tangible such as equipment, livestock, artwork, etc were exchangeable for like-kind assets. Businesses, investment property, and specific fractional real estate ownership structures qualify as like-kind. A primary residence, secondary home, or vacation home is and has never been eligible for a 1031 exchange. Homeowners may qualify for up to $500,000 in capital gains tax relief when the residence is sold and meets the I.R.S.’s home sale exclusion requirements. However, homeowners may qualify for up to $500,000 in capital gains tax relief on the sale of a residence if they meet the I.R.S.’s home sale exclusion criteria.
Closing Thoughts
1031 Exchanges are complex transactions that require experts with adequate experience to ensure that you are successful. At NNN Invest, we help navigate our clients through the process of commercial real estate investing. If you are interested in NNN investing, please contact us so that one of our specialists can further assist you.