What Kind of Property Qualifies for a 1031 Exchange?
If you are thinking about selling your real estate investment property, a 1031 Exchange is the best strategy for you - and your bank account!
A 1031 Exchange allows you to defer capital gains taxes indefinitely by providing the opportunity of transferring the tax liability of your current property to your new one(s). That means you can use a 1031 Exchange to sell your investment property and acquire another one without having to pay any federal taxes on profits at the time of sale. The best part about this tax loophole is that it can continue indefinitely - even after you have passed - without saddling your loved ones with a hefty tax liability on your behalf.
In order to take full advantage of this tax-deferred strategy, you are required to exchange your current property for another “Like-Kind” property or properties. This is why a 1031 Exchange is also recognized as a Like-Kind Exchange.
Identifying Like-Kind Property
The term “Like-Kind” property may not mean what you think. To qualify for a 1031 Exchange, your current property and the identified property or properties do not have to be the same type, they just have to serve the same purpose. An exchange is “like-kind” if your property is being used as an investment or for income-producing purposes, and you replace it with another investment or income-producing property. Real property is generally considered to be like-kind regardless of whether the properties are improved or unimproved, and doesn’t necessarily mean a house for a house.
For example, you may sell a residential duplex and buy a small office complex, or you could sell a vacant lot and opt for a number of single-family rental properties to replace it.
There is a simple three-step test for identifying whether a property qualifies for a 1031 Exchange or not.
- The investor’s purpose and intent in holding the property is the most important part because both the relinquished and the replacement property must be held either for investment purpose or productive use in a trade or business and cannot be held for personal use.
- Properties must be Like-Kind, meaning properties must be similar enough but not necessarily identical. Like-Kind refers to the nature, character, or class of the property and not to the grade or quality. For example, unimproved real property, such as raw land, is considered Like-Kind to improved real property, such as an apartment complex or any other commercial building.
- One of the most important conditions for any property to qualify for a 1031 Exchange is that both the relinquished and replacement properties must be located within the United States and US Territories.
In simple terms, any real property which is held for productive use – that is, use in a trade or business or for investment – is considered ike-kind. What properties do not qualify for a 1031 Exchange?
The range of properties that qualify for a 1031 Exchange is extremely broad. However, there are some properties that are specifically excluded from a 1031 Exchange.
The following will disqualify you from being eligible for a 1031 Exchange:
- Personal property usually does not qualify for an exchange because it is not used in trade, business or investment. This would include a primary residence and a second or vacation home.
- You cannot buy property that you intend to “flip” quickly for profit.
- While you can sell a property to a related party, you cannot purchase the replacement property from a related party.
- You cannot buy or sell property outside of the United States.
If you have any questions about completing a 1031 Exchange, submit the form below and we will happily help you reach your real estate investing goals!