When a real estate investor sells a property, they might be eligible for a deferment of capital gains taxes through a 1031 Exchange if they purchase a replacement property called a like-kind property.
So, what exactly does the IRS consider a like-kind property?
The term is misleading to some people who assume it means that the replacement property must be similar in type and quality to the sold investment. However, a like-kind property can be almost any type of real estate.
Defining a Like-Kind Property
One of the most important factors in defining a like-kind property is that it must be an investment or for business use. It cannot be for personal living of any sort, including a vacation home or a second home.
Besides being an investment and not a personal residence, a like-kind property:
- Does not need to be in the same location as the exchange property, although both must be in the United States.
Example: An investor can exchange a property sold in Texas for an investment in Michigan.
- Can be a different type of real estate as long as it is of equal or greater value.
Example: An apartment building can be exchanged for farmland, or an office building can be exchanged for a retail property.
- Does not need to be a one-to-one exchange.
Example: Even if the investor relinquished one property, the exchange could be for multiple properties, and vice versa. Again, the caveat is that the value must be equal to or greater value.
- Can be exchanged into a Replacement Property Interest (RPI), where the investor will share equity ownership with other investors.
Example: An investor can hold part ownership in a property if they do not want to self-manage the property.
- Can be a property held in a Delaware Statutory Trust (DST) where investors combine their 1031 exchange funds into the trust.
Example: An inherited property is sold into a DST, maintaining equity but separating themselves from the property.
Additional examples of like-kind property exchanges include unimproved property for improved property, vacant land for a resort property, or a duplex home for an office building, among others.
Implications to Consider
While the definition of a like-kind property seems to be broad, there are some things to keep in mind.
- After the exchange, if the IRS finds the property to not be like-kind, the sale will be subject to capital gains taxes.
- The investor must use proceeds of the relinquished property for the like-kind property within 180-days.The exchange property must be identified within 45-days of the sale of the original investment.
- A property within the United States cannot be considered like-kind to a property outside of the United States.
- Again, to reiterate, the property must be for business use or an investment and cannot be used as a personal residence by the taxpayer in any form.
- The like-kind property must be held as an investment for appreciating value, for business-use, or to generate income, and not just for resale or flipping.
