When you sell an investment property for more than what you paid for, you will likely incur a capital gain and have to pay taxes on it at the time of sale. However, Internal Revenue Code Section 1031 provides an exception to this rule if you reinvest your capital gains into a similar property. This type of transaction is referred to as a “like-kind exchange," allowing you to defer the taxes you would have otherwise had to pay. Fortunately, the exchange rules are fairly broad and allow investors a great deal of latitude in their choices.
So what exactly qualifies?
In order for your exchange to be completely tax-deferred, the property you sell and the property you purchase must have certain qualities.
- The purpose of both properties must be exclusively for investment or business use. Properties for personal use, such as your primary residence or vacation home, generally do not qualify for a 1031 exchange—though there are exceptions.
- Both properties must be like-kind, which means they are of the same character or nature, even if they differ in grade or quality. There is a great deal of flexibility within this definition. Properties do not need to be of the same type, nor located in the same state. For example, a rental home in California may be exchanged for an industrial building in Virginia; raw land in Michigan may be exchanged for a retail building in Texas.
What does not qualify?
Despite the flexibility allowed in a like-kind exchange, certain assets do not qualify. Sales or purchases that do not meet all of the exchange requirements are subject to taxes in the year they sell. These include:
- Transactions involving non-real estate assets such as inventory, stocks and bonds, notes or loans, or certificates of trust usually do not qualify for a tax-deferred exchange. However, oil and gas rights are typically considered like-kind.
- Property held primarily for resale also does not meet the requirements. Example include “fix-and-flip” homes and land development (land subdivided and sold off as individual lots).
- Partnership interests do not qualify. However, the partnership itself may exchange one property for another. Note that there may be options for investors seeking to exchange out of or into a partnership
A 1031 exchange can be a powerful investment tool, allowing investors to grow their wealth on a tax-deferred basis. However, bear in mind that there are several like-kind exchange rules that must be followed to complete a valid exchange. We encourage interested investors to consult their accountant and financial advisors prior to selling their investment properties.