Ever since the 1031 exchange was introduced through the Revenue Act of 1921, swapping like-kind property held for investment or trade has been successfully used to help defer capital gains taxes. But over the years, questions have arisen about property that is eligible for exchange.
There are good reasons for this confusion. During its century of existence, the 1031 exchange has gone through many iterations, overhauls, and variations. At one time, businesses and individuals could exchange aircraft, vehicles, artwork, and coin collections, as long as the replacement property was “like-kind.”
So, can inventory be considered an eligible asset for a like-kind exchange?
The immediate answer is “no.” 26 U.S. Code § 1031 is adamant that the process applies only to real property that is “held for productive use in a trade or business, or for investment . . .” Because of the Tax Cuts and Jobs Act of 2017, other types of capital assets, such as the above-mentioned aircraft, vehicles, or artwork (along with intellectual property or patents) can’t be exchanged to defer capital gains taxes.
Defining Inventory
The main reason inventory isn’t eligible for a like-kind exchange is because of what it is. Specifically, inventory is an asset slated for sale in the ordinary course of a business. Inventory consists of three classifications:
- Raw materials, which are used to produce finished goods
- Work-in-process, describing items that are being produced, but are not yet ready for sale
- Finished goods, representing ready-to-sell items
Certainly, as assets, some business inventory might be similar to real property. It can be eligible for depreciation. And it could provide a return if sold or leased. But there is a difference between an asset sold in the ordinary course of doing business and one that is real estate.
So, What Is Real Property?
Real property includes:
- Land and land improvements
- Unsevered crops and other “natural products of land, and water and air space superjacent to land . . .”
- Inherently permanent structures (such as bridges, roads, and buildings)
None of the above fits under “inventory.”
But similar to many rules under the IRS auspices, there is a gray area when it comes to eligible property for 1031 treatment. According to the Journal of Accountancy, the following might be considered real property if:
- It is built into the real property’s permanent structure, such as certain types of wiring that can’t be removed
- It doesn’t produce or contribute to income production, other than for use or occupancy of space
- It is customarily transferred with that of acquired real property, as long as the fair market value of the personal property doesn’t exceed 15% of the fair market value of the real property
For example, a natural gas line connected to a furnace might fall under the category of real property. But if that same gas line feeds into an oven, it isn’t.
The Rule of Thumb
Even with the above examples, the likelihood is strong that your business inventory won’t qualify as relinquished or replacement property under the 1031 exchange parameters. On the other hand, your office building or land on which that building sits, likely will.
As for any gray areas that might occur (such as the direction and connection of your natural gas line), more research is necessary. As such, another rule of thumb is to check with your financial expert when it comes to any like-kind exchange questions or concerns.
