For those not familiar with 1031 exchanges, the definition and application of like-kind requires an explanation to fully appreciate the breadth and depth. 1031 like-kind exchanges were first legislated as part of the National Revenue Act of 1921. 1031 exchanges were created under the premise that when a taxpayer reinvests the sale proceeds into another like-kind property, the economic gain has not been realized (creating the funds to pay the capital gains tax). The taxpayer’s economic position is the same, only the property has changed, as in land for an investment rental property. Consequently, to pay the tax when the replacement property of equal or greater value is acquired is unfair. Rather, when the replacement property is sold, the deferred gain from the original property plus any additional gain realized since the purchase of the replacement property is subject to tax. If another 1031 exchange is initiated, the tax is deferred.
Like-Kind Property Definition
The 1031 exchange code states that no gain or loss shall be recognized on the exchange of property held for productive use in trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held for productive use in trade or business or for investment. Property held in the United States is considered like-kind with property held in the United States, while property held internationally is like-kind with property held internationally.
State laws also determine whether a property is considered real or personal as is the case of water rights and options. Does the state consider mobile homes in a mobile home park personal or real property?
Like-Kind Application
In a 1031 exchange, the real property application is broad, allowing real property to be exchanged for any real property. Real property exchanges consider factors including “the respective interests in the physical properties, the nature of the title conveyed, the rights of the parties, and the duration of the interests” per Koch v. Commissioner of Internal Revenue, 1978. Examples of real property exchanges include:
- Land for an apartment building
- 30 year leasehold interest for timberland
- Single family rental for percentage interest in a Delaware Statutory Trust
- Improved real estate for unimproved real estate
What is not eligible for 1031 consideration is:
- Primary residence
- Partnership interests
- Stocks, bonds or securities
- Debt
- Inventory
Understanding what property is eligible for a 1031 exchange is one of the first steps to understanding the value of 1031 exchanges. For a complimentary eBook on “Ten Reasons Why a 1031 Makes Sense,” click here to receive your copy instantaneously.
