1031 Exchange Rules: What Can Qualify as Like-Kind Property 1031 Exchange Rules: What Can Qualify as Like-Kind Property
The 1031 exchange process can be complicated, but if you're a real estate investor it's important to know the ins and outs of Section 1031 of the U.S. Tax Code (or consult with a Qualified Intermediary who does) so you can be sure to defer capital gains tax on property transactions.
Key Takeaways
- 1031 exchanges allow investors to defer capital gains taxes on the sale of investment properties through an exchange of like-kind replacement property(ies).
- The term “like-kind” refers to how the real estate asset must be used or held for investment purposes.
- Property that does not qualify includes but is not limited to a primary residence, a second home, flip properties, or a property held in inventory for sale.
- Recent changes to tax law disallow personal property (artwork, boats, etc.) as valid property in a 1031 Exchange at the federal level.
One of the most important parts of the 1031 Exchange process is identifying a replacement property that is like kind to the property that is being sold. But what exactly counts as a like-kind property? How similar do properties have to be in a like-kind exchange? What other factors should real estate investors take into account when searching for a replacement, like-kind property in a 1031 exchange? We'll dive into these questions and more below to answer any questions you have about what qualifies as like-kind in a 1031 exchange.
What is Like-Kind Property in a 1031 Exchange?
First of all, to provide a brief refresher on what a 1031 exchange is -- IRS Code Section 1031 grants investors the opportunity to defer capital gains taxes on the sale of real estate held for productive use in a trade business or for investment purposes by exchanging into like-kind replacement property(ies). To be eligible for a 1031 exchange, the exchange of property must involve real estate held for investment purposes and does not apply to primary or second homes.
By allowing real estate investors to defer capital gains taxes on the sale of investment property, 1031 exchanges provide a meaningful path to potential wealth building. For full tax deferral, the exchanger must reinvest the net equity from the sale of their relinquished property and acquire a property with the same or greater debt.
So with all of this in mind, what exactly can be considered like-kind property in a 1031 exchange? How similar does the replacement property actually have to be to the property being sold to qualify? Whereas all “real property” may qualify, the term like-kind refers to how the real estate asset must be used or held for investment purposes. For example, commercial real estate can be exchanged for a single-family vacation rental property.
What Doesn't Qualify as Like-Kind in a 1031 Exchange?
While it may seem like "like-kind" is a broad term that encompasses many different types of property, there are certain limits and restrictions set out in Internal Revenue Code Section 1031 as to what properties qualify for a 1031 exchange.
Property that does not qualify includes but is not limited to a primary residence, a second home, flip properties, or a property held in inventory for sale. When considering a 1031 exchange, it's important to note that recent changes to tax law disallow personal property (artwork, boats, etc.) as valid property in a 1031 Exchange at the federal level.
How to Identify a Property for Like-Kind Exchange
So now that we've outlined what type of property can qualify as like-kind in a 1031 exchange, how should real estate investors go about finding like-kind property that is eligible for a 1031 exchange?
To avoid capital gains tax, you must unambiguously identify the replacement property with an address or legal description in writing that is signed by the taxpayer initiating the exchange and send it within 45 days after the relinquished property is sold.
There are three general rules that investors must follow when identifying like-kind real estate in a 1031 exchange:
- Three-Property Rule: The investor may identify up to three properties regardless of value; or
- 200% Rule: They may identify any number of properties so long as the total fair market value of all the identified properties does not exceed 200% of the value of the sold property. NOTE: Exceeding 200% of the value will cause a third rule to apply (the “95% Rule”);
- 95% Rule: If the investor identifies more than three properties, and the combined value of all identified properties exceeds 200% of the value of the relinquished property, the taxpayer must acquire at least 95% of all identified properties, or the entire exchange will fail.
It goes without saying that the 1031 exchange process is complicated, so it's important for real estate investors to surround themselves with a team of professionals to ensure all due diligence is done in identifying and exchanging properties.
How to Get Started Identifying Like-Kind Property for a 1031 Exchange
As mentioned above, the first thing real estate investors should do when looking to initiate a 1031 exchange is to assemble a team of professionals to guide them through the intricacies of the process. This includes a tax advisor, a realtor, and most importantly, a qualified intermediary or QI. Finding the right qualified intermediary to work with is crucial to the 1031 exchange process because it helps verify the security of your funds and provides your entire team with knowledge and experience that they might not otherwise have.
Your qualified intermediary will interact with your realtor, tax advisor, escrow professional, and representatives for the property you are purchasing, so it's extremely important to make sure you choose a QI who can guide your team through the complexities of the process while meeting all of the important associated deadlines.
Leader Bank's 1031 exchange subsidiary, Leader1031*, serves as a qualified intermediary for real estate investors seeking to sell and purchase property using the tax-deferred advantages of a 1031 exchange. These services provide greater integration and efficiencies for our commercial real estate clients, and Leader1031 is committed to providing the highest quality of service.
As soon as your relinquished property has gone into contract, you can set up a 1031 Exchange account with Leader1031. This 1031 Exchange account and property legal documentation provided by your QI must be in place prior to the close of your relinquished property sale.
Leader1031 is ready to help ensure your transactions are in full compliance with IRS Code Section 1031 and related Treasury regulations. Contact Leader1031 today by email at 1031Exchange@LeaderBank.com or click below to learn more.
The content of this publication is provided as general information only and should not be taken as legal, investment or other professional advice. This content of this publication shall not be construed as a recommendation to participate in any particular trading, financial or investment strategy, and neither Leader Bank, NA nor Leader1031.com, LLC can provide legal or tax advice concerning the specific tax consequences of a given transaction. Any action that you take as a result of information or opinions provided in this publication is ultimately your responsibility. Consult your attorney, accountant, or tax professional before making any investment or financial decisions.
To ensure compliance with requirements under Treasury Department Circular 230, we inform you that the contents of this publication are not intended or written to be used, and may not be used, for the purpose of (i) avoiding U.S. federal tax penalties or (ii) promoting, marketing, or recommending to another party any matter addressed herein. Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax adviser.
