What Qualifies for a 1031 Exchange?

Real estate investors who sell a property can sometimes take advantage of a section in the U.S. IRS’ tax code that allows them to defer capital gains or losses on the property. This is called a 1031 exchange, after the section of tax code that offers this benefit.

But like most IRS tax-related processes, there are certain qualification requirements that taxpayers must meet to be eligible. According to the IRS, to defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same or like kind as the property sold. You also must hold both properties for business, productive use in a trade, or investment (26 U.S.C. § 1031(a)).

But if you’re doing a 1031 exchange for the first time, you may be asking the question, what qualifies as the same or like kind? What types of properties are not allowed? Keep scrolling to find out.

What is a Like-Kind Property?

According to the IRS, like-kind property is defined as:

“Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. Also, improvements that are conveyed without land are not of like-kind to land.”

To fully understand the IRS definition of a like-kind property, it is first necessary to understand two terms, relinquished property and replacement property. The relinquished property is the property that you sold in a delayed exchange and the replacement property is the new property that you purchased with the realized funds from the sale.

A like-kind property must be an investment property, not a personal one. According to the IRS,

“Both the relinquished and replacement properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.”

Property does not qualify as like-kind if one property is in the U.S. and another is outside of it. Additionally, you may be able to exchange a property for a stake in a Delaware Statutory Trust (DST) under certain circumstances, given changes in the tax code. If you want to learn more about doing a 1031 exchange into DST, we’ll be glad to talk to you. 

If you’re doing a 1031 exchange for the first-time, this can be challenging. If a property is not actually “like-kind”, the IRS will tax you the full amount of the sale but you may not find out until you file forms to claim the 1031 exchange tax defer benefits. Therefore, it helps to understand some basic restrictions on 1031 exchanges before proceeding.

Like-Kind Property Restrictions

Real property and personal property can both qualify as like-kind property; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks. 

IRC § 1031(a)(2) specifically provides that real property held primarily for sale does not qualify for tax deferral under section 1031.

Following are examples of qualifying properties that could be exchanged:

• Raw land or farmland for improved real estate
• Oil & gas royalties for a ranch
• Fee simple interest in real estate for a 30-year leasehold or a Tenant-in-Common interest in real estate
• Residential, Commercial, Industrial or Retail rental properties for any other real estate
• Rental ski condo for a three-unit apartment building
• Mitigation credits for restoring wetlands for other mitigation credits

Under IRC §1031, the following properties do not qualify for tax-deferred exchange treatment:

• Stock in trade or other property held primarily for sale (i.e. property held by a developer, “flipper” or other dealer)
• Securities or other evidences of indebtedness or interest
• Stocks, bonds, or notes
• Certificates of trust or beneficial interests
• Interests in a partnership
• Choses in action (rights to receive money or other property by judicial proceeding)
• Foreign real property for U.S. real property
• Goodwill of one business for goodwill of another business

Given the various interpretations of the definition of “like-kind,” it is recommended to involve a qualified intermediary like Sera Capital when attempting a 1031 exchange or doing a 1031 exchange into a DST. The benefits of such an exchange could be powerful, but if you  unknowingly tries to exchange properties that are not defined by the IRS as like-kind, you may end up getting stuck with a hefty tax bill.

If you want to learn more about DSTs and how they can help you defer capital gains tax, diversify your portfolio, and generate passive income for you, then you schedule a call with us today.

Or learn more about Delaware Statutory Trusts and 1031 Exchanges or DST Fees and Commissions.