If you are thinking of selling real property that you use in your trade or business or that you are holding for investment, you should consider the benefits of a like-kind exchange.
What is a like kind exchange?
In a like-kind exchange, you do not recognize any gain or loss on the disposition of real property held for the productive use in a trade or business or for investment if you dispose of the property by exchanging it solely for property of like kind that is to be held either for productive use in a trade or business or for investment.
Gain Recognized if ‘Boot’
If, in addition to receiving like-kind property, you receive cash or other property that does not qualify as like-kind property (so-called “boot”), you must recognize gain to the extent of the boot received.
In a like-kind exchange, the gain realized on the exchange of real property for replacement property does not escape tax – the tax on the gain is merely deferred until you sell the replacement property. However, by deferring the tax, you’ll have more money available to invest in another property. In effect, you receive an interest-free loan from the federal government, in the amount you would have paid in taxes. Also, any gain from depreciation recapture is postponed except to the extent you receive boot as part of the exchange and recognize gain. Further, because of the way the term “like kind” is defined, you may use the acquisition and disposition of properties to reallocate your investment portfolio (e.g., moving from commercial rental property to residential rental property) without paying tax on any gain.
IRC 1031 Qualification
To qualify as a like-kind exchange, both the property you give up (the relinquished property) and the property you receive (the replacement property) must be held for
- investment or
- productive use in your trade or business.
While taxpayers were able to use the like-kind exchange rules for exchanges of personal property in years beginning before 2018, such exchanges are no longer available for federal income tax purposes. Only real property is eligible for the like-kind exchanges rules. Examples of property that may qualify include land, farm property, commercial and rental houses.
The like-kind exchange rules do not apply to real property held primarily for sale. Unproductive real estate held by someone other than a dealer for future use or future realization of the increment in value is considered held for investment and not primarily for sale.
Also, to qualify as a like-kind exchange, the replacement property must be of a “like kind” to the relinquished property. “Like kind” refers to the nature and character of the property and not to its grade or quality. An exchange of one kind or class of property for a different kind or class is not a like-kind exchange. All qualifying real property located in the United States, improved or unimproved, is considered to be of like kind.
Additional requirements apply to deferred like-kind exchanges in which you do not receive the replacement property immediately upon your transfer of the relinquished property.