The 1031 exchange, established by the IRS, is a powerful tax-deferral strategy that allows real estate investors to sell a property and reinvest the proceeds into a like-kind property, deferring capital gains taxes. Governed by strict rules and timelines, this process helps investors build wealth while continuing to invest in similar types of real estate without an immediate tax burden. Understanding the nuances of these regulations is key to leveraging their benefits effectively. Compliance with specific rules and timelines is crucial for maintaining eligibility for tax deferral.
A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows investors to swap one investment property for another while deferring capital gains taxes 2. The main purpose is to allow real estate investors to reinvest proceeds from the sale of a property into another “like-kind” property without triggering immediate tax liability 4
Both the sold and replacement properties must serve business or investment purposes. Properties do not have to be identical (e.g., you can exchange a rental home for a commercial building), as long as both qualify as investment or business-use real estate.
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same kind as the property sold. You also must hold both propertie
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same 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 what qualifies as the same kind? What types of properties are not allowed? See our video below to find out.
s for business, productive use in a trade, or investment (26 U.S.C. § 1031(a)).
But what qualifies as the same kind? What types of properties are not allowed? See our video below to find out. As its name suggests, a replacement property is “like-kind” to a relinquished property if they are similar assets. For example, farmland is like-kind to other farmland. However, like-kind properties need not be exactly the same. (After all, no two properties are exactly the same. If they were, they would be one single property, with the same floor plan, tenant, and address. No one wants to exchange a property for itself.) So how similar do two assets have to be if they are to be like-kind to each other? Generally, any real estate asset counts as “like-kind” to any other, so long as both are held for business, productive use in a trade, or investment.
So farmland is not only like-kind to other farmland, but also is like-kind to apartment buildings, raw land, and industrial properties. Further, all these property types can even count as like-kind to fractional ownership interests in Delaware statutory trusts (learn more about DST shares).
According to the IRS, “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” (FS 2008-18).
You can understand “quality” generally as the value of a property, however that is measured. Two properties can differ in market value, differ in square footage or in age, or differ in whether they are improved or unimproved, yet still count as like in kind.
Replacement property does not have to be in the same state jurisdiction as relinquished property. But national borders matter. Property within the United States may be exchanged for other U.S. property. Property outside the United States may be exchanged for other property outside the U.S.
Replacement property does not have to be in the same class as relinquished property. Commercial, residential, undeveloped, and developed property are all like-kind to each other. So each is exchangeable with each.
Not all real estate “ownership” carries the same property rights. One may hold either permanent or temporary rights, either to the land or what is improvements to the land, or both. Properties do not have to be held with the same rights to be considered like-kind.
But there are some restrictions:
Generally, rental homes, condo buildings, and apartments are all like-kind, so are eligible for 1031 like-kind exchanges. Such property types are like-kind for two reasons. First, they generate income through lease and rental agreements. Second, they are not owned primarily for personal use.
If a property owner resides at the rental property relinquished, then different parts of the property may be treated as distinct. The rental portion of the property is considered like-kind. The portion used as a personal residence is not. Further, the residential portion may qualify for capital gains tax relief under the Taxpayer Relief Act Of 1997. With this provision, a single-filing taxpayer can exempt $250,000 of capital gains liability. Married couples can exempt up to $500,000.
Before attempting a 1031 like-kind exchange, you should consult with a qualified professional about your particular situation.
We’ve seen that what it takes to be “like-kind” is pretty broad. Are there any restrictions on what qualifies as “like-kind” property? The next few sections dig into the details.
According to the IRS, to count as like-kind, a property must be “held for productive use in a trade, or business, or for investment”. This holds for both your relinquished property and replacement property.
This means that you must own and operate both properties for one of the following purposes:
A primary residence, second home, or vacation property does not qualify as investment or business property. Likewise for properties “held for resale”.
If the IRS determines that you hold property primarily for (re)sale instead of for investment, that property won’t count as like-kind. Simply put, a property held for sale or resale is one bought just to be “flipped”.
There is no single set of criteria that the IRS uses to draw this distinction. Rather, the IRS considers the property owner’s intent at the time of sale and their use of the property throughout its ownership period. If the IRS determines that the property owner did not intend to use property for business or investment purposes, it will be considered as held for sale.
To determine intent, the IRS may consider several factors, including:
Like-kind properties in the Virgin Islands, Guam, or the Northern Mariana Islands may count as like-kind. Foreign real property in the other eleven US Territories (including Puerto Rico) is not considered like-kind to domestic American real estate. Since there are no special provisions made for these other US Territories, they fall under the general rule given in § 1031(h):
“real property located in the United States and real property located outside the United States are not property of a like kind”.
Not any longer.
Before the Tax Cuts & Jobs Act of 2017, tangible property like farm equipment, livestock, artwork, and even baseball players were exchangeable for assets like in kind. Now, only businesses, real investment property, and certain real estate fractional ownership structures qualify as like-kind.
Personal property such as a primary residence, second home, or vacation home has never been eligible for a 1031 exchange. However, homeowners may qualify for up to $500,000 in capital gains tax relief on the sale of a residence if they meet the IRS’s home sale exclusion criteria.
According to the IRS Fact Sheet on 1031 Exchanges, none of the following are considered “like-kind” for the purposes of a 1031 Exchange.
Now that you understand what does and doesn’t count as like-kind property, read about the IRS’s rules about how to identify like-kind replacement property. Or head over to our property archive to see examples of DST offerings that qualify as like-kind.
You have 45 days from the sale date to identify potential replacement properties. and you must close on the new property within 180 days of selling the original property.
However, there are a number of other rules that real estate investors must follow when performing a 1031 exchange. If these rules are not followed, the sale of an investor’s relinquished property becomes a taxable event, and the investor may needlessly lose 20–35%+ of their capital gain.
Among these rules is a requirement that the investor must identify potential replacement property that will be held for use in a trade or business or for investment, that is like-kind to the original property, by midnight on the 45th day after the sale of the original property. This identification must be done in a particular way, and the replacement property that the investor actually acquires to complete their exchange must be on that official list of identified properties.1 The number of properties an investor may identify, and their total market value, are restricted according to one of those three classic identification rules, which an investor may choose between to suit the particulars of their situation.
This article answers the following questions:
In order to defer capital gains taxes on the sale of property under IRC § 1031, both the relinquished property and the replacement property must be held for productive use in a trade or business,2 or for investment. There are two keys to understanding what this means: intent and predominant use.
Intent. 1031 exchange property does not have to be actively generating revenue to qualify as property held for business or investment purposes. The owner’s intent is the key, and there are many facts that an investor can document to prove intent. Note well, however, that property held primarily for sale (or “inventoried”) does not qualify as property held for investment.
Predominant use. 1031 exchange property does not have to be exclusively held for business or investment purposes. Its predominant use is the key. To clarify the meaning of “predominant use”, the IRS provides investors with a “safe harbor”, or a set of clear guidelines for taxpayers to follow to remain well within the intent of the law. In this case the IRS says that if the safe harbor guidelines are followed it will not challenge a property’s business or investment intent. The safe harbor provided for 1031 exchange property identification uses an example involving rental property. It says that if:
the IRS will not challenge the owner’s intent to hold that property for investment.
In a 1031 exchange, the replacement property in a 1031 exchange must be “like-kind”3 to the relinquished property. The sense of “kind” here is broad; real estate in general is like-kind,4 although movable (“personal”) property is not like-kind to immovable (“real”) property.
Replacement property does not have to be in the same state jurisdiction as relinquished property, however the national borders matter: Property within the United States may be exchanged for property that is also within the U.S., and property outside the U.S. may be exchanged for other property outside the U.S.
Replacement property does not have to be in the same class as relinquished property. Commercial, residential, undeveloped, and developed property are all like-kind and may be exchanged with one another.6
Not all real estate “ownership” carries the same property rights. One may hold either permanent or temporary rights, either to the land or what is improvements to the land, or both. Properties do not necessarily have to be held with the same rights to be considered like-kind, however there are some restrictions. Property held with permanent rights to the land and its improvements (“fee-simple”) is like-kind to property held with permanent rights to the land but not the improvements (“leased fee”). Either property may be like-kind to property held with rights to the improvements (“leasehold interest”) and temporary rights to the land (“ground lease”), as long as there is more than 30 years left in the term, including renewal provisions. Shorter-term leasehold interests can qualify as like-kind to one another, but not to property held long-term. Lastly, buildings or other improvements held without any rights to their underlying land are not like-kind to any real property. Similarly, stocks, bonds, notes, traditional securities,7 partnership interests, and certificates of trust are not eligible for 1031 exchange.
To successfully defer capital gains taxes on the sale of investment property by way of a 1031 exchange, an investor must identify, in writing, potential replacement property in compliance with certain rules, by the 45th day after the disposition of the relinquished property. The day after the close of escrow is Day #1. The identification period closes at midnight of Day #45, with both weekends and holidays included in the countdown. Deadlines cannot be extended unless the President of the United States deems it necessary, such as in cases of natural disasters or national emergencies.
In order to comply with one of the three rules discussed below, property identifications may be revoked during this 45-day period. This may be necessary if an investor’s needs or goals change, or if the situation with any of the identified property changes. Note well that neither identification nor revocation alters the 1031 exchange timeline.
[Calculate your 1031 exchange timeline here.]
An investor must comply with one of three rules provided by the IRS for identifying potential replacement properties and ultimately acquiring some or all of them. These rules place constraints on the number and total market value of the potential replacement properties identified and acquired.
An investor may identify up to three potential replacement properties, regardless of their total market value, and acquire any or all of them.
An investor may identify any number of potential replacement properties if their total value does not exceed 200% of the relinquished property’s total value by the end of the identification period. The investor may then acquire any or all of the properties as desired.
An investor may identify any number potential replacement properties as desired, regardless of their value, if the investor acquires 95% of the total market value of all properties identified.
To officially identify a replacement property, an investor must produce a written notice that is signed and hand-delivered, mailed, emailed, or faxed. In the case of real estate, this notice must include an unambiguous description of each property, such as including a legal description, street address, assessor’s parcel number, and/or recognized building name. The more detail supplied, the better.
If the investor is complying with the 200% rule and acquiring a fractional interest in property held by investors as Tenants-in-Common (TIC) or by way of a Delaware Statutory Trust (DST), the percentage or dollar amount being considered for acquisition should be supplied in the notice. Failing to do so may signal to the IRS that 100% of the property is being considered, which may invalidate the 1031 exchange, either because the 200% rule was not followed, or because a substantially different property was ultimately acquired than what was identified.
This identification notice is most often sent to an investor’s Qualified Intermediary (QI), however legally it can also be sent to:
The notice may not be sent to the investor’s:
The close of escrow on a replacement property, or signing of a Letter of Intent, prior to the end of the identification period may also satisfy the written property identification requirement. However, if a replacement property is acquired prior to the 45th day, any properties that have already been identified should be revoked to avoid violating one of the three rules.
Do you want to talk with trusted professionals about finding potential replacement property to identify? Are you looking for 1031 exchange property that meets certain needs? Fill out the form to the right and we will connect you with the appropriate 1031 exchange expert to answer your questions and help you facilitate your exchange.
1 The property that the investor acquires must remain “substantially the same” as the property identified. The nature, grade, or class of property cannot be significantly different from what was officially identified. Consider the case in which an investor identifies property that includes a barn, its underlying land, and an adjoining acre, but only acquires the barn and its underlying land. The investor has not acquired substantially the same property that was identified, which invalidates the exchange.
2 “Trade or business” generally refers to any service performed within the U.S., although it doesn’t include work done as an employee or work performed for foreign entities that are not doing business in the U.S. Trading stocks or securities for oneself doesn’t count as “doing business”, and trading on behalf of others counts as doing business as long as a fixed place of business inside the U.S. is used to direct the trading (cf. 26 USC § 1.864-2). The distribution and sale of gas, steam, electricity, water, and waste management may be excluded or severely restricted (cf. 26 USC § 163(j)(7)(A)).
3 According to the IRS, “The exchange of real estate for real estate and the exchange of personal property for similar personal property are exchanges of like-kind property. For example, the trade of land improved with an apartment house for land improved with a store building” (Publication 544).
4 According to the IRS, “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” (FS 2008-18).
5 Inclusive of Washington D.C., Guam, the U.S. Virgin Islands and the Northern Mariana Islands
6 As long as the residential property is not the investor’s personal residence (in which case a 121 exclusion may be a viable option) or vacation home
7 Real estate ownership interests structured as securities may be acquired in a 1031 exchange in the case of Tenant-in-Common (Rev. Proc. 2002-22) and Delaware Statutory Trust (Rev. Rul. 2004-86) investments
3 Property Rule, 200% Rule and 95% Rule. The IRS doesn't want you to identify a bunch of properties as "failsafes" and then have you pick only one. They have implemented specific guidelines and options to choose from for identification.
As the timing on your 1031 exchange becomes imminent, tax advice and exchange expertise are recommended to avoid missing important deadlines and violating IRS guidelines to complete a successful tax-deferred exchange. This article will touch on three related topics concerning the 1031 exchange. First, it will provide a basic understanding of closing statements. Second, it will demonstrate how to calculate the amount required to avoid tax liability. Third, it will explain the 200% rule based on clarifications regarding the first two topics.
When it comes to closing statements, particularly where expenses are concerned, professional guidance is especially useful since the IRS has not published a complete list of qualified non-taxable expenses—and interpretation may vary between CPAs. One of the goals of this article is to clarify which transaction costs will be subsidized by the exchange and which others could be deemed boot if they are not offset in the transaction.
The exchange code stipulates that the net proceeds of the sale from the relinquished property will be taxable if not fully reinvested. As simple as this concept seems, varied costs could trigger some tax liability if processed incorrectly. For more-detailed information, you may click this link to the IRS Fact Sheet on Like-Kind Exchanges under IRS Code Section 1031.
We can simplify our approach by separating items in the closing statement into two categories: expenses and costs.
Here we will define expenses as any items related to owning a rental property. This is notable because expenses could offset capital gains when the relinquished property is sold. Generally speaking, these expenses belong in the Schedule E section on a tax return. Expenses, based on this explanation, include the following:
Costs, on the other hand, will include any items directly related to selling said property. The first generally acknowledged cost that can be deducted from the replacement liability is the real estate broker’s commissions and referrals fees. We can also deduct from the sales price other transactional costs listed below:
Be aware of money spent that might not easily fit into either of these two categories. Furthermore, be prepared to do a little more digging into the closing statement to be able to properly categorize these line items. In a recent transaction, I had a client come across an item labeled “Bankruptcy Liquidating Trust” in a closing statement. In order to determine how exactly this should be labeled in the transaction, we had to analyze the item and label it according to its relation to the sale (cost) or the rental property (expense). In this case, “Bankruptcy Liquidating Trust” turned out to be a disposition fee, and thus it qualified as a cost of the sale. If doubts still stand, a CPA or escrow company may be able to clarify or help further analyze the item.
When analyzing your closing statement, two facts are important to consider. First, the costs of selling your property will reduce the net sales price, which will determine the amount required to be replaced in the 1031 exchange. The more in costs you can document, the easier it will be to find a replacement property that will meet your needs. Furthermore, reducing your net sales price reduces your capital gain. Since your basis in the replacement property will be determined by the purchase price less the gain deferred in the exchange, the more you can document, the higher your new basis will be. This will give you that much more in potential depreciation to take and that much less in recognizable gain if and when you ever realize that gain in a taxable sale down the road.
Second, the expenses related to owning the property will offset capital gains, decreasing your tax exposure when you finally cash out. Furthermore, any cash that ends up in the seller’s hands rather than going through a qualified intermediary will be considered boot. If you took money out to pay expenses that you did not document on your closing statement, you will be taxed on it.
There are three possible identification rules for an exchange: the three-property rule, the 200% rule, and the 95% rule. Understanding the details of a closing statement is essential to completing a successful 1031 exchange when using the 200% identification rule because the 200% rule involves a number of important numerical limits that must be met that relate to the net proceeds of the property sold. We will focus on how to determine the limits on the 200% rule.
The first aspect of this rule allows the identification of an unlimited number of replacement properties so long as the total dollar value of what is being acquired does not exceed 200% of the sales price of the property sold. A common misunderstanding regarding this rule is that one must double the net proceeds (gross sales price – costs = net proceeds) to reach the 200% limit amount. In actuality, to determine the 200% identification value, one will advantageously double the gross sales price of the relinquished property to define the upper limit of the total value of the properties that you can identify.
By following this rule the correct way, one will be able to identify an unlimited number of replacement properties whose aggregate worth does not exceed 200% of the gross sales price, while being required to utilize only 100% of the net proceeds to comply with the 1031 exchange and avoid boot. In most transactions, depending on the amount of leverage on the property that was sold, this means that an investor essentially gets to double the number of options for reinvestment, typically providing much greater flexibility than what the three-property or 95% identification rules provide.
There are dozens of line items that find their way onto the average closing statement. In order to maximize the usefulness of a closing statement, one must identify expenses and costs in order to determine their true 1031 requirement and net equity proceeds. Expenses will offset capital gains. Costs aid in determining the net proceeds, which will be used to find the required amount to be replaced in a 1031 exchange. In addition, doubling the gross sales price stated in the closing statement will establish the limit for the 200% identification rule. Once you have these parameters in mind, you are better prepared to complete a successful 1031 exchange.
A Qualified Intermediary (QI) must receive and hold the sale proceeds, temporarily, and redeploy the proceeds into the replacement property(ies) which has already been identified. The investor cannot touch the funds to maintain the tax-deferred status of the exchange.
Real estate owners can legally defer capital gains taxes with a 1031 exchange. In delayed exchanges, which are the most common, Qualified Intermediaries receive the funds from the sale of the relinquished property and forward them for the acquisition of the replacement property. (Reverse 1031 exchanges also require Qualifies Intermediaries.)
This article answers the following questions:
If an exchange does not comply with certain tenants of the U.S. tax code or IRS regulations, the IRS will treat it as a taxable sale and an investor may lose 20–35% of their capital gain as a result. One of these rules specifies that if an investor receives any of the funds from the sale directly (actual receipt) or even receives control of those funds (constructive receipt), the money becomes taxable. The regulations are pretty strict about what counts as “constructive receipt” of funds—for example, even the delivery of a physical check that never gets cashed may count as “constructive receipt”, which would render that money taxable.
While this rule may be simple enough to comply with in the case of a simultaneous exchange, which only requires one escrow, such cases are rare and difficult to coordinate. Most 1031 exchanges are delayed, or “Starker”, exchanges, which allow for two closings: one for the disposition of the original property and a subsequent closing for the acquisition of the replacement property.
In order for an investor to avoid receiving funds from the sale of their original property, federal regulations allow the proceeds to be held by a third party—the “Qualified Intermediary” or “QI”. This way the investor defers the receipt of any capital gain, and therefore defers the recognition of any gain on their taxes.
Qualified Intermediaries can sometimes be referred to as a “Facilitators” or “Accommodators”, and they typically support investors throughout the entire 1031 exchange process, helping them with all the necessary tax and legal paperwork required for a successful exchange.
It’s important for investors to be aware of the federal requirements that relate to Qualified Intermediaries so they can know what to expect during the exchange. Investors are ultimately the ones who will be held responsible for their property and any tax obligations that result from its disposition. Not only that, but the federal government does not require Qualified Intermediaries to obtain any special license in order to do business, and they do not actively supervise them to make sure they are complying with federal regulations and treating investors fairly. It is up to investors to make sure they understand the law and select a reputable QI in order to avoid unnecessarily high tax bills (or fraud). In reality, most QIs are reliable, and with a just little bit of education an investor can successfully carry out a 1031 exchange without any worry. Keep reading to learn about these federal requirements.
Given the principles explained above, it may already be obvious that an investor cannot serve as their own Qualified Intermediary. What might not be as obvious is that nobody who is acting as an investor’s “agent”, or who has acted as their agent within the two years prior to the exchange, may serve as the investor’s Qualified Intermediary. An agent is someone who acts on behalf of someone else. Someone acting as an investor’s agent is therefore in an important sense under the investor’s control, or representative of them, so that if an investor’s agent receives any funds from the sale of the original property, the IRS treats it as though the investor received them. The term ‘agent’ is intended to be broad, encompassing family members, employers, accountants, investment brokers, real estate agents, and attorneys.
However, IRS regulations do specify that providing certain services to an investor does not automatically disqualify someone from being their QI. These include routine financial, insurance, escrow, and trust services. And of course, just serving as an investor’s QI doesn’t count as being someone’s agent in the sense that would be disqualifying, or else these transactions couldn’t ever happen.
The good news for investors is that a number of professional Qualified Intermediaries have established reputations for being fair and trustworthy over the course hundreds or thousands of 1031 exchange transactions.
The individual or entity that sold the original property must also be the one purchasing the replacement property for the exchange to qualify. The IRS looks at Tax ID for applying the tax deferral benefits.
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same kind as the property sold. You also must hold both propertie
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same 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 what qualifies as the same kind? What types of properties are not allowed? See our video below to find out.
s for business, productive use in a trade, or investment (26 U.S.C. § 1031(a)).
But what qualifies as the same kind? What types of properties are not allowed? See our video below to find out. As its name suggests, a replacement property is “like-kind” to a relinquished property if they are similar assets. For example, farmland is like-kind to other farmland. However, like-kind properties need not be exactly the same. (After all, no two properties are exactly the same. If they were, they would be one single property, with the same floor plan, tenant, and address. No one wants to exchange a property for itself.) So how similar do two assets have to be if they are to be like-kind to each other? Generally, any real estate asset counts as “like-kind” to any other, so long as both are held for business, productive use in a trade, or investment.
So farmland is not only like-kind to other farmland, but also is like-kind to apartment buildings, raw land, and industrial properties. Further, all these property types can even count as like-kind to fractional ownership interests in Delaware statutory trusts (learn more about DST shares).
According to the IRS, “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” (FS 2008-18).
You can understand “quality” generally as the value of a property, however that is measured. Two properties can differ in market value, differ in square footage or in age, or differ in whether they are improved or unimproved, yet still count as like in kind.
Replacement property does not have to be in the same state jurisdiction as relinquished property. But national borders matter. Property within the United States may be exchanged for other U.S. property. Property outside the United States may be exchanged for other property outside the U.S.
Replacement property does not have to be in the same class as relinquished property. Commercial, residential, undeveloped, and developed property are all like-kind to each other. So each is exchangeable with each.
Not all real estate “ownership” carries the same property rights. One may hold either permanent or temporary rights, either to the land or what is improvements to the land, or both. Properties do not have to be held with the same rights to be considered like-kind.
But there are some restrictions:
Generally, rental homes, condo buildings, and apartments are all like-kind, so are eligible for 1031 like-kind exchanges. Such property types are like-kind for two reasons. First, they generate income through lease and rental agreements. Second, they are not owned primarily for personal use.
If a property owner resides at the rental property relinquished, then different parts of the property may be treated as distinct. The rental portion of the property is considered like-kind. The portion used as a personal residence is not. Further, the residential portion may qualify for capital gains tax relief under the Taxpayer Relief Act Of 1997. With this provision, a single-filing taxpayer can exempt $250,000 of capital gains liability. Married couples can exempt up to $500,000.
Before attempting a 1031 like-kind exchange, you should consult with a qualified professional about your particular situation.
We’ve seen that what it takes to be “like-kind” is pretty broad. Are there any restrictions on what qualifies as “like-kind” property? The next few sections dig into the details.
According to the IRS, to count as like-kind, a property must be “held for productive use in a trade, or business, or for investment”. This holds for both your relinquished property and replacement property.
This means that you must own and operate both properties for one of the following purposes:
A primary residence, second home, or vacation property does not qualify as investment or business property. Likewise for properties “held for resale”.
If the IRS determines that you hold property primarily for (re)sale instead of for investment, that property won’t count as like-kind. Simply put, a property held for sale or resale is one bought just to be “flipped”.
There is no single set of criteria that the IRS uses to draw this distinction. Rather, the IRS considers the property owner’s intent at the time of sale and their use of the property throughout its ownership period. If the IRS determines that the property owner did not intend to use property for business or investment purposes, it will be considered as held for sale.
To determine intent, the IRS may consider several factors, including:
Like-kind properties in the Virgin Islands, Guam, or the Northern Mariana Islands may count as like-kind. Foreign real property in the other eleven US Territories (including Puerto Rico) is not considered like-kind to domestic American real estate. Since there are no special provisions made for these other US Territories, they fall under the general rule given in § 1031(h):
“real property located in the United States and real property located outside the United States are not property of a like kind”.
Not any longer.
Before the Tax Cuts & Jobs Act of 2017, tangible property like farm equipment, livestock, artwork, and even baseball players were exchangeable for assets like in kind. Now, only businesses, real investment property, and certain real estate fractional ownership structures qualify as like-kind.
Personal property such as a primary residence, second home, or vacation home has never been eligible for a 1031 exchange. However, homeowners may qualify for up to $500,000 in capital gains tax relief on the sale of a residence if they meet the IRS’s home sale exclusion criteria.
According to the IRS Fact Sheet on 1031 Exchanges, none of the following are considered “like-kind” for the purposes of a 1031 Exchange.
Now that you understand what does and doesn’t count as like-kind property, read about the IRS’s rules about how to identify like-kind replacement property. Or head over to our property archive to see examples of DST offerings that qualify as like-kind.
Any remaining proceeds from the sale of the relinquished property, not redeployed into an eligible replacement property is referred to as “boot” may be taxable. Example: If the replacement property is worth less than the original, the difference may be taxed.
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same kind as the property sold. You also must hold both propertie
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same 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 what qualifies as the same kind? What types of properties are not allowed? See our video below to find out.
s for business, productive use in a trade, or investment (26 U.S.C. § 1031(a)).
But what qualifies as the same kind? What types of properties are not allowed? See our video below to find out. As its name suggests, a replacement property is “like-kind” to a relinquished property if they are similar assets. For example, farmland is like-kind to other farmland. However, like-kind properties need not be exactly the same. (After all, no two properties are exactly the same. If they were, they would be one single property, with the same floor plan, tenant, and address. No one wants to exchange a property for itself.) So how similar do two assets have to be if they are to be like-kind to each other? Generally, any real estate asset counts as “like-kind” to any other, so long as both are held for business, productive use in a trade, or investment.
So farmland is not only like-kind to other farmland, but also is like-kind to apartment buildings, raw land, and industrial properties. Further, all these property types can even count as like-kind to fractional ownership interests in Delaware statutory trusts (learn more about DST shares).
According to the IRS, “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” (FS 2008-18).
You can understand “quality” generally as the value of a property, however that is measured. Two properties can differ in market value, differ in square footage or in age, or differ in whether they are improved or unimproved, yet still count as like in kind.
Replacement property does not have to be in the same state jurisdiction as relinquished property. But national borders matter. Property within the United States may be exchanged for other U.S. property. Property outside the United States may be exchanged for other property outside the U.S.
Replacement property does not have to be in the same class as relinquished property. Commercial, residential, undeveloped, and developed property are all like-kind to each other. So each is exchangeable with each.
Not all real estate “ownership” carries the same property rights. One may hold either permanent or temporary rights, either to the land or what is improvements to the land, or both. Properties do not have to be held with the same rights to be considered like-kind.
But there are some restrictions:
Generally, rental homes, condo buildings, and apartments are all like-kind, so are eligible for 1031 like-kind exchanges. Such property types are like-kind for two reasons. First, they generate income through lease and rental agreements. Second, they are not owned primarily for personal use.
If a property owner resides at the rental property relinquished, then different parts of the property may be treated as distinct. The rental portion of the property is considered like-kind. The portion used as a personal residence is not. Further, the residential portion may qualify for capital gains tax relief under the Taxpayer Relief Act Of 1997. With this provision, a single-filing taxpayer can exempt $250,000 of capital gains liability. Married couples can exempt up to $500,000.
Before attempting a 1031 like-kind exchange, you should consult with a qualified professional about your particular situation.
We’ve seen that what it takes to be “like-kind” is pretty broad. Are there any restrictions on what qualifies as “like-kind” property? The next few sections dig into the details.
According to the IRS, to count as like-kind, a property must be “held for productive use in a trade, or business, or for investment”. This holds for both your relinquished property and replacement property.
This means that you must own and operate both properties for one of the following purposes:
A primary residence, second home, or vacation property does not qualify as investment or business property. Likewise for properties “held for resale”.
If the IRS determines that you hold property primarily for (re)sale instead of for investment, that property won’t count as like-kind. Simply put, a property held for sale or resale is one bought just to be “flipped”.
There is no single set of criteria that the IRS uses to draw this distinction. Rather, the IRS considers the property owner’s intent at the time of sale and their use of the property throughout its ownership period. If the IRS determines that the property owner did not intend to use property for business or investment purposes, it will be considered as held for sale.
To determine intent, the IRS may consider several factors, including:
Like-kind properties in the Virgin Islands, Guam, or the Northern Mariana Islands may count as like-kind. Foreign real property in the other eleven US Territories (including Puerto Rico) is not considered like-kind to domestic American real estate. Since there are no special provisions made for these other US Territories, they fall under the general rule given in § 1031(h):
“real property located in the United States and real property located outside the United States are not property of a like kind”.
Not any longer.
Before the Tax Cuts & Jobs Act of 2017, tangible property like farm equipment, livestock, artwork, and even baseball players were exchangeable for assets like in kind. Now, only businesses, real investment property, and certain real estate fractional ownership structures qualify as like-kind.
Personal property such as a primary residence, second home, or vacation home has never been eligible for a 1031 exchange. However, homeowners may qualify for up to $500,000 in capital gains tax relief on the sale of a residence if they meet the IRS’s home sale exclusion criteria.
According to the IRS Fact Sheet on 1031 Exchanges, none of the following are considered “like-kind” for the purposes of a 1031 Exchange.
Now that you understand what does and doesn’t count as like-kind property, read about the IRS’s rules about how to identify like-kind replacement property. Or head over to our property archive to see examples of DST offerings that qualify as like-kind.
The debt replacement rule allows investors to replace existing mortgage debt with either new debt or additional cash to match or exceed the debt retired from the relinquished property to maintain the balance of leverage and tax-deferred benefits.
In the realm of real estate investments, 1031 exchanges offer a powerful tool for deferring capital gains taxes when swapping one investment property for another of like-kind. One critical aspect of this exchange, often overlooked but crucial for maximizing tax benefits, is the debt replacement rule.
What is the Debt Replacement Rule?
The debt replacement rule applies to investors looking to defer taxes on capital gains through a 1031 exchange while ensuring they maintain or increase their debt load associated with the exchanged property. When selling a relinquished property, any existing mortgage debt paid off must be replaced with new debt or additional cash to match or exceed the amount of debt retired from the relinquished property. This replacement ensures that the investor maintains a comparable level of leverage in the replacement property.
Key Considerations:
1. Equal or Greater Debt: To fully defer capital gains taxes, the investor must reinvest all net proceeds and replace any mortgage debt retired from the relinquished property with new debt or additional cash of equal or greater value.
2. Impact on Basis: The basis of the replacement property is adjusted based on the amount of debt replaced. If the investor chooses not to replace the entire debt amount, the basis of the replacement property will be reduced accordingly, potentially increasing taxable gains upon future sale.
Benefits of Debt Replacement:
– Preservation of Tax Deferral: By adhering to the debt replacement rule, investors maintain or increase their leverage, crucial for maximizing tax deferral benefits under Section 1031.
– Flexibility in Financing: Investors have the flexibility to structure their replacement property acquisitions with new financing options that best suit their investment strategy, including securing favorable interest rates or terms.
– Enhanced Investment Potential: Maintaining or increasing leverage through debt replacement allows investors to potentially acquire higher-value replacement properties or diversify their real estate portfolio without immediate tax consequences.
The debt replacement rule in 1031 exchanges serves as a strategic mechanism for investors to defer capital gains taxes while maintaining or increasing leverage in their real estate investments. Understanding and effectively applying this rule can significantly impact the financial outcomes of property exchanges, making it essential for investors to consult with qualified tax advisors and real estate professionals to navigate the complexities and optimize their investment strategies.
Both the relinquished and replacement properties must be held for investment or productive business use—not for personal use. Example: Primary residences or vacation homes do not qualify.
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same kind as the property sold. You also must hold both propertie
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same 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 what qualifies as the same kind? What types of properties are not allowed? See our video below to find out.
s for business, productive use in a trade, or investment (26 U.S.C. § 1031(a)).
But what qualifies as the same kind? What types of properties are not allowed? See our video below to find out. As its name suggests, a replacement property is “like-kind” to a relinquished property if they are similar assets. For example, farmland is like-kind to other farmland. However, like-kind properties need not be exactly the same. (After all, no two properties are exactly the same. If they were, they would be one single property, with the same floor plan, tenant, and address. No one wants to exchange a property for itself.) So how similar do two assets have to be if they are to be like-kind to each other? Generally, any real estate asset counts as “like-kind” to any other, so long as both are held for business, productive use in a trade, or investment.
So farmland is not only like-kind to other farmland, but also is like-kind to apartment buildings, raw land, and industrial properties. Further, all these property types can even count as like-kind to fractional ownership interests in Delaware statutory trusts (learn more about DST shares).
According to the IRS, “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” (FS 2008-18).
You can understand “quality” generally as the value of a property, however that is measured. Two properties can differ in market value, differ in square footage or in age, or differ in whether they are improved or unimproved, yet still count as like in kind.
Replacement property does not have to be in the same state jurisdiction as relinquished property. But national borders matter. Property within the United States may be exchanged for other U.S. property. Property outside the United States may be exchanged for other property outside the U.S.
Replacement property does not have to be in the same class as relinquished property. Commercial, residential, undeveloped, and developed property are all like-kind to each other. So each is exchangeable with each.
Not all real estate “ownership” carries the same property rights. One may hold either permanent or temporary rights, either to the land or what is improvements to the land, or both. Properties do not have to be held with the same rights to be considered like-kind.
But there are some restrictions:
Generally, rental homes, condo buildings, and apartments are all like-kind, so are eligible for 1031 like-kind exchanges. Such property types are like-kind for two reasons. First, they generate income through lease and rental agreements. Second, they are not owned primarily for personal use.
If a property owner resides at the rental property relinquished, then different parts of the property may be treated as distinct. The rental portion of the property is considered like-kind. The portion used as a personal residence is not. Further, the residential portion may qualify for capital gains tax relief under the Taxpayer Relief Act Of 1997. With this provision, a single-filing taxpayer can exempt $250,000 of capital gains liability. Married couples can exempt up to $500,000.
Before attempting a 1031 like-kind exchange, you should consult with a qualified professional about your particular situation.
We’ve seen that what it takes to be “like-kind” is pretty broad. Are there any restrictions on what qualifies as “like-kind” property? The next few sections dig into the details.
According to the IRS, to count as like-kind, a property must be “held for productive use in a trade, or business, or for investment”. This holds for both your relinquished property and replacement property.
This means that you must own and operate both properties for one of the following purposes:
A primary residence, second home, or vacation property does not qualify as investment or business property. Likewise for properties “held for resale”.
If the IRS determines that you hold property primarily for (re)sale instead of for investment, that property won’t count as like-kind. Simply put, a property held for sale or resale is one bought just to be “flipped”.
There is no single set of criteria that the IRS uses to draw this distinction. Rather, the IRS considers the property owner’s intent at the time of sale and their use of the property throughout its ownership period. If the IRS determines that the property owner did not intend to use property for business or investment purposes, it will be considered as held for sale.
To determine intent, the IRS may consider several factors, including:
Like-kind properties in the Virgin Islands, Guam, or the Northern Mariana Islands may count as like-kind. Foreign real property in the other eleven US Territories (including Puerto Rico) is not considered like-kind to domestic American real estate. Since there are no special provisions made for these other US Territories, they fall under the general rule given in § 1031(h):
“real property located in the United States and real property located outside the United States are not property of a like kind”.
Not any longer.
Before the Tax Cuts & Jobs Act of 2017, tangible property like farm equipment, livestock, artwork, and even baseball players were exchangeable for assets like in kind. Now, only businesses, real investment property, and certain real estate fractional ownership structures qualify as like-kind.
Personal property such as a primary residence, second home, or vacation home has never been eligible for a 1031 exchange. However, homeowners may qualify for up to $500,000 in capital gains tax relief on the sale of a residence if they meet the IRS’s home sale exclusion criteria.
According to the IRS Fact Sheet on 1031 Exchanges, none of the following are considered “like-kind” for the purposes of a 1031 Exchange.
Now that you understand what does and doesn’t count as like-kind property, read about the IRS’s rules about how to identify like-kind replacement property. Or head over to our property archive to see examples of DST offerings that qualify as like-kind.
An improvement exchange allows investors to use exchange funds to make upgrades or improvements to the replacement property before finalizing the purchase.
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same kind as the property sold. You also must hold both propertie
To defer paying capital gains taxes using a 1031 like-kind exchange, your replacement property must be of the same 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 what qualifies as the same kind? What types of properties are not allowed? See our video below to find out.
s for business, productive use in a trade, or investment (26 U.S.C. § 1031(a)).
But what qualifies as the same kind? What types of properties are not allowed? See our video below to find out. As its name suggests, a replacement property is “like-kind” to a relinquished property if they are similar assets. For example, farmland is like-kind to other farmland. However, like-kind properties need not be exactly the same. (After all, no two properties are exactly the same. If they were, they would be one single property, with the same floor plan, tenant, and address. No one wants to exchange a property for itself.) So how similar do two assets have to be if they are to be like-kind to each other? Generally, any real estate asset counts as “like-kind” to any other, so long as both are held for business, productive use in a trade, or investment.
So farmland is not only like-kind to other farmland, but also is like-kind to apartment buildings, raw land, and industrial properties. Further, all these property types can even count as like-kind to fractional ownership interests in Delaware statutory trusts (learn more about DST shares).
According to the IRS, “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” (FS 2008-18).
You can understand “quality” generally as the value of a property, however that is measured. Two properties can differ in market value, differ in square footage or in age, or differ in whether they are improved or unimproved, yet still count as like in kind.
Replacement property does not have to be in the same state jurisdiction as relinquished property. But national borders matter. Property within the United States may be exchanged for other U.S. property. Property outside the United States may be exchanged for other property outside the U.S.
Replacement property does not have to be in the same class as relinquished property. Commercial, residential, undeveloped, and developed property are all like-kind to each other. So each is exchangeable with each.
Not all real estate “ownership” carries the same property rights. One may hold either permanent or temporary rights, either to the land or what is improvements to the land, or both. Properties do not have to be held with the same rights to be considered like-kind.
But there are some restrictions:
Generally, rental homes, condo buildings, and apartments are all like-kind, so are eligible for 1031 like-kind exchanges. Such property types are like-kind for two reasons. First, they generate income through lease and rental agreements. Second, they are not owned primarily for personal use.
If a property owner resides at the rental property relinquished, then different parts of the property may be treated as distinct. The rental portion of the property is considered like-kind. The portion used as a personal residence is not. Further, the residential portion may qualify for capital gains tax relief under the Taxpayer Relief Act Of 1997. With this provision, a single-filing taxpayer can exempt $250,000 of capital gains liability. Married couples can exempt up to $500,000.
Before attempting a 1031 like-kind exchange, you should consult with a qualified professional about your particular situation.
We’ve seen that what it takes to be “like-kind” is pretty broad. Are there any restrictions on what qualifies as “like-kind” property? The next few sections dig into the details.
According to the IRS, to count as like-kind, a property must be “held for productive use in a trade, or business, or for investment”. This holds for both your relinquished property and replacement property.
This means that you must own and operate both properties for one of the following purposes:
A primary residence, second home, or vacation property does not qualify as investment or business property. Likewise for properties “held for resale”.
If the IRS determines that you hold property primarily for (re)sale instead of for investment, that property won’t count as like-kind. Simply put, a property held for sale or resale is one bought just to be “flipped”.
There is no single set of criteria that the IRS uses to draw this distinction. Rather, the IRS considers the property owner’s intent at the time of sale and their use of the property throughout its ownership period. If the IRS determines that the property owner did not intend to use property for business or investment purposes, it will be considered as held for sale.
To determine intent, the IRS may consider several factors, including:
Like-kind properties in the Virgin Islands, Guam, or the Northern Mariana Islands may count as like-kind. Foreign real property in the other eleven US Territories (including Puerto Rico) is not considered like-kind to domestic American real estate. Since there are no special provisions made for these other US Territories, they fall under the general rule given in § 1031(h):
“real property located in the United States and real property located outside the United States are not property of a like kind”.
Not any longer.
Before the Tax Cuts & Jobs Act of 2017, tangible property like farm equipment, livestock, artwork, and even baseball players were exchangeable for assets like in kind. Now, only businesses, real investment property, and certain real estate fractional ownership structures qualify as like-kind.
Personal property such as a primary residence, second home, or vacation home has never been eligible for a 1031 exchange. However, homeowners may qualify for up to $500,000 in capital gains tax relief on the sale of a residence if they meet the IRS’s home sale exclusion criteria.
According to the IRS Fact Sheet on 1031 Exchanges, none of the following are considered “like-kind” for the purposes of a 1031 Exchange.
Now that you understand what does and doesn’t count as like-kind property, read about the IRS’s rules about how to identify like-kind replacement property. Or head over to our property archive to see examples of DST offerings that qualify as like-kind.