The term “like-kind exchange” describes the federal and state capital gains tax deferral strategy requirement of an Internal Revenue Code (IRC) Section 1031 tax deferred exchange that properties exchanged must be like-kind to one another. A 1031 exchange effectively defers the gain triggered by the sale that can represent upwards of 40 percent of the property’s sales price. The like-kind exchange represents an indefinite, interest free loan that is due when the replacement property is sold, unless the basis is stepped up to the taxpayer’s heirs or another like-kind exchange is initiated.
1031 Code
The IRC Code states “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.” Eligible property includes both real and personal property held in the United States and internationally. Property not eligible includes the primary residence, partnership interests, stocks and securities, indebtedness and inventory.
Real and Personal Property
Real property can be exchanged for any real property given the location of the property sold. Property held in the United States is exchanged for property within the United States while real property held outside the United States can be exchanged for any property held internationally. For example, real property held by a US taxpayer in Singapore can be exchanged for real property held in India. Personal property is far more confining and must be exchanged for like-kind or like class personal property. Thirteen General Asset Codes, in addition to the North American Industry Classification System, categorize personal property into codes based upon the nature or character or the property. Personal property like-kind exchanges include furniture for furniture, aircraft for aircraft, trucks for trucks, oil paintings for oil paintings and silver bullion for silver bullion.
IRS ILM 201238027
In recent legal memorandum (ILM) 201238027, the Internal Revenue Service (IRS) provided the view that federal income tax law rather than state law controls whether a property is considered like-kind. Before, state law was considered the determining factor as to whether property was considered real or personal property for tax purposes.
The ILM focuses on the exchange of natural gas pipelines and steam turbines that previously hinged on the location or state to determine whether the property was treated as real or personal property. The IRS concludes that pipelines are treated as real property given they are permanently affixed to real property for an indefinite period of time and conveyed as part of the land title. Steam turbines are personal property given they are not permanently affixed and not considered an inherent structure. The ILM will most likely impact future like-kind exchanges of mineral interests, timber, and water rights.
The like-kind exchange requirement is fundamental to qualifying for a 1031 exchange. The Regulations require that one kind or property class cannot be exchanged for a different kind or class of property. Like-kind applies to the property’s nature or character and not to its grade or quality. Real property cannot be exchanged for personal property while unimproved real property or land can be exchanged for improved real property such as a single family rental or condominium held for investment and not primarily for personal use. The application of a like-kind exchange also encompasses the likeness of physical properties, character of title and rights transferred and duration of interests.
When selling real or personal property held in a business or for investment, be sure to discuss with your tax advisor whether a like-kind exchange makes sense. What are the tax implications of the sale? Is the intent to replace the property? Download a complimentary eBook discussing “Ten Reasons Why a 1031 Exchange Makes Sense,” by clicking on the button below.
