In most cases, selling an investment property triggers a big tax bill. A 1031 exchange helps you defer that cost. If done right, an exchange can ensure your funds keep working for you rather than heading to the IRS.
To use a 1031 exchange, you must understand the IRS like-kind exchange rules. If you choose the wrong property, the potential benefits associated with the sale can evaporate.
Per like-kind exchange rules, both properties must be similar. But what does that really mean to the average investor? Let’s answer that question.
What Is a 1031 Exchange?
Before we discuss the like-kind exchange rules, let’s briefly recap 1031 exchanges. The IRS sanctioned these transactions, allowing real estate investors to defer the tax burden from the sale of one property by purchasing something similar.
In a transaction like this, you’ll sell one investment property and place the funds in the hands of a qualified intermediary. You’ll identify an eligible property, and you’ll use the sales funds for that purchase. Instead of paying taxes on the sale, you’ll roll that obligation into the new property.
If you sell that second property down the line, the tax bill will come through at that time. However, if you hang onto that investment until your death, your heirs won’t be required to cover that tax.
While a 1031 exchange can be a helpful tool for investors, the rules are complicated. Getting even one part wrong could mean triggering tax liabilities for the entire sale. Understanding what properties are eligible is an important part of your homework.
Eligible Properties per Like-Kind Exchange Rules
To qualify for a 1031 exchange, you must choose a property that the IRS considers “like kind” to the one you’ve sold. These are two pieces of a dependent transaction of similar investments. The following requirements apply to like-kind properties:
They Are Investment Properties
Per IRS like-kind exchange rules, both properties must be used for business or investment purposes. You can’t use this type of transaction to trade something like a summer home for an office building. You also can’t use your primary residence as either part of the transaction. Instead, you can use this transaction to keep your business investment money circulating.
They Are in the Same Country
This is among the trickier like-kind exchange rules. Properties within the United States can’t be considered like-kind to properties in another country. You can’t use an exchange like this to sell a property in Dublin, Ohio, to buy one in Dublin, Ireland. Both properties have to be in the same country.
They Have Equal or Greater Value
The property you identify must be worth the same (or more) than the one you’re selling. Essentially, you can’t pull out some of the money from the sale and keep it while rolling the rest into something else. You can pull together several replacement properties and buy them with the proceeds of the sale. For example, you could sell an office building for several standalone rentals. Just keep an eye on that bottom line to ensure it adds up correctly.
Factors That Don’t Matter Per Like-Kind Exchange Rules
While several factors are crucial in choosing a like-kind property, a surprising number of issues just don’t seem to matter at all. Here are a few things you just don’t have to consider when shopping for the right property for your 1031 exchange:
Property Quality
The IRS says the two properties don’t have to match in terms of quality or grade. In other words, you can sell a bright and shiny new apartment building and buy a run-down facility in an emerging neighborhood.
You’re not required to prove that these investments are so similar that people can’t tell them apart. In fact, they can be very different in terms of their condition.
Primary Use
You’re not required to stick with the same type of investment when considering a 1031 exchange. For example, if you’ve sold an office building, you’re not required to shop for more office buildings.
As long as you’re dealing with real estate used for investment or business purposes, it’s typically considered like kind. It doesn’t matter what that property is generally used for, so you have some flexibility in terms of property type. You could sell a commercial office space and purchase a residential apartment complex.
Specific Location
We’ve mentioned that your exchange must involve two properties in the same country. However, you’re not required to pick two that are in the same city, state, or county. You’re not even required to pick two within the same type of location, such as rural or urban. You can diversify your portfolio by choosing something far from home in this exchange, and the IRS won’t block it on those grounds.
How to Find Like-Kind Properties
As a savvy real estate investor, you may already have a few properties picked out for a potential exchange. If you don’t, it’s time to go shopping.
Know that most properties you’ll use for business or investments are considered like kind. If you’re eyeing something that another investor is using for these purposes, the sale should fly through nicely. For example, if you see an office building up for sale, chances are that it’s eligible for your exchange.
However, approach riskier properties with caution. For example, if you’re hoping to buy a home someone is living in right now and eventually use it as an investment after you live in it for a few years, this may not be a smart choice. Stick with properties that are clearly investments.
The less gray area, the better in terms of ensuring your transaction is solid. Getting an expert to guide you through the process helps to ensure it’s done right.
Get Help With Your 1031 Exchange
Finding a property that meets like-kind exchange rules is just part of a successful 1031 transaction. You must also meet deadlines, transfer funds, and file the appropriate paperwork. Let us help.
At 1031 Pros, we specialize in these complex financial transactions. We can help you identify a property, complete the second transaction, and file the right paperwork. We’ve helped thousands of investors just like you handle these purchases like pros. Contact us to find out more.
References
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
Like-Kind Exchanges of Real Property. (January 2022). Journal of Accountancy.
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