As explained in theirs code, like kind property is property of the same nature, character or class, regardless of quality or grade, and they must be used for investment or business purposes.
This is an important distinction because when a real estate investors sells a property and buys a replacement one within the allowed timeframe, the owner can defer paying capital gain taxes and recapture to the IRS.
Any type of investment or business real estate property can be exchanged for a like-kind property. For example, you can exchange vacant land for a hotel, or an investment apartment building for a hotel. That is what it means being of a similar nature, character or class.
What Qualifies As Like-Kind Property?
Properties that qualify for a like-kind exchange do not need to be an exact match; whether improved or unimproved, nearly all real estate property qualifies, including the following
- Rental houses, apartments, duplex, single-family homes, etc.
- Office buildings, commercial properties, industrial buildings,
- Farms, vacant land,
- Retails buildings, restaurants, malls, and shopping centers.
Thus, vacant land can qualify as like-kind real estate and could be exchanged for an investment house.
The key requirements to be considered like-kind are:
- The investment must be in real estate (real property).
- The property must be used for investment or business purposes.
- The properties must be located in the U.S.A.
Size, quality, or the condition of the properties do not matter. Also, it is irrelevant what the previous owner used the property for; what matters is that, you, as the new owner must have the intent to hold the property for investment or for business purposes.
IRS Tax Code Section 1031
Section 1031 of the IRS tax code allows you to defer paying taxes on capital gains you earn when exchanging like-kind properties. The transaction needs to be properly structure and both the relinquished and the replacement properties must be used for investment or business purposes.
The idea is that if you are simply exchanging a real estate asset for another like-kind property; therefore no economic benefit is realized, much like taking a $20 bill from your pocket on the left and moving it to your pocket on the right.
So, if a real estate investor sells a rental house he/she has to buy another property, he or she does not have to pay capital gain tax if the transactions are structured as a 1031 exchange and they meet the criteria.
What Properties Do Not Qualify As Like-Kind?
A like-kind property cannot be used for personal purposes; thus a primary residence, or the place where you live, does not qualify for a 1031 exchange.
Properties acquired with the sole intent to resell do not qualify for a 1031 exchange. That includes house flips, or what people refer to as “dealer” properties.
In addition, like-kind properties do not include the following:
- Real estate property outside of the U.S. (foreign real estate property).
- Stocks, bonds, or notes even if the underlying holdings are in real estate.
- Inventory, stock in trade even if it is real estate related.
Why Does Like-Kind Real Estate Qualify For 1031 Tax Deferment?
The reasons why like-kind properties qualify for a 1031 tax deferment is because you are exchanging an investment properties for another one instead of buying and selling.
Even if you are exchanging a property for a value that’s higher than what you paid for it, the gain is transferred, as an unrealized gain, the new property.
For example, let’s say you are exchanging a property worth $100,000 but you paid for it $80,000. Using a 1031 exchange, and assuming the transaction qualifies, you can transfer the $20,000 gain, unrecognized, to the new property. Since you don’t get the benefit or receiving the cash, you don’t have to pay tax on the $20,000 gain.
Pros and Cons of Like-Kind Real Estate 1031 Exchange
The main reason why real estate investors exchange like-kind properties is that it allows them to better allocate those funds to keep building wealth.
The downside is that there is a tight deadline to meet the requirements and you will need to hire a qualified intermediary to make sure the transaction is processed in accordance to the 1031 exchange rules.
- You can defer capital gains tax payments.
- You can build more real estate wealth using Uncle Sam’s money.
- There is a lot of flexibility in the types of property you can exchange as long as you intend to use them for business or investment purposes.
- Transactions can be complicated which means you will need to hire a third party intermediary.
- You need to identify a replacement property within 45 days of selling the relinquished property and close on it within 180 days.
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The Bottom Line
Exchanges of like-kind properties play avital role in the engine of the U.S. economy. In 2015, Erns and Yonge published an influential study (Synopsis of EY Study) where it highlights empirical evidence about the importance contribution like-kind property exchanges have over the U.S. economy.
To sum up, nearly any real estate property that’s not your principal residence, qualifies as like-kind as long as you intend to use the property for business or investment purposes. Vacation homes, don’t fall under that category but they may also qualify.
Be sure to hire a qualified intermediary so you can make sure your like-kind exchange goes according to your plan.