After researching 1031 exchanges, you might find yourself wondering what “like-kind property” really means when it comes to real estate. It’s a vague and sometimes misunderstood term when it comes to tax deferred exchanges.
The Internal Revenue Code defines like-kind properties as those that have been held for productive use in a business or trade, or as an investment. Like-kind, as used in this code section, means a property that is “similar in nature or character, regardless of differences in grade or quality.”
Still not clear?
Basically, the code says that the property to be sold and the property to be bought must be qualified business or investment properties. This is why you can’t sell your own personal residence and expect 1031 tax deferral benefits.
A property that has been used in a taxpayer’s business, including his/her place of office, is a qualified property. Additionally, any real property that is held as an investment also qualifies for 1031 treatment.
A common misconception about like-kind property is that when you exchange one property for another, they both have to be the same size and/or type. This is not the case. Real property can be exchanged for another real property and still be eligible for capital gains tax deferral.
For example, raw land can be exchanged for an office building; a strip mall can be exchanged for a single-tenant, triple net investment property; and a rental house can be exchanged for fractional ownership in a high-rise apartment complex.
One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not like-kind to land.
Real property involved in a 1031 exchange simply needs to be in the real estate realm and held as an investment to qualify as a business property, and to ensure the deferral of capital gains tax.
