Understanding the Like Kind Requirement
Potential investors investigating 1031 exchanges likely know of the "like-kind" requirement for the replacement property to provide investment continuity from the surrendered property. However, that does not mean a taxpayer must acquire an apartment building or invest in multifamily real estate to replace an apartment building.
The like-kind requirement has existed since IRC Section 1031 was added to the tax code in 1921. However, the basis precedes Section 1031 and comes from what is known as the "continuity of investment" doctrine. This doctrine justifies a tax deferment by the fact that the taxpayer is continuing investment from one property into a similar kind of property. The reasoning is that because the taxpayer did not receive any type of profit from the exchange, the investment has essentially just changed form. The doctrine, therefore, asserts that no tax should be triggered because the taxpayer isn't receiving any cash profit from the sale.
How that concept is actually applied and enforced has significant implications for taxpayers considering a 1031 exchange. So, what exactly does like-kind mean?
Fortunately, the interpretation for 1031 exchanges is rather broad. All real property is generally considered like-kind to all other real property in relation to a 1031 exchange. The asset class or specific type of property is irrelevant. For example, an investor who brings an apartment building into a 1031 exchange could acquire virtually any other type of real estate as replacement property, such as undeveloped land for sale, an office or industrial building, a retail shopping center, or even an interest in a Delaware Statutory Trust (DST).
The key requirements to qualify as replacement property for a 1031 exchange are:
- The property is considered real property under applicable rules
- The investor intends to hold the property for a qualified purpose, such as business or investment
- The replacement property is properly identified within 45 days of the sale of relinquished property
- The replacement property is acquired within 180 days of the sale of the relinquished property
For many years, taxpayers could include personal property in a 1031 exchange. However, in 2018, the Tax Cuts and Jobs Act amended the law, making personal property exchanges ineligible for tax deferral under Section 1031.
How, then, can a taxpayer determine whether they are looking at real property or personal property for purposes of Section 1031
Real Estate Interests That Qualify as Like-Kind
The most basic definition of real property is a piece of land with or without a structure or improvement on it. Even the nature of the structure is largely irrelevant. It doesn't have to be something that can be rented out or leased. Further, even vacant land does not have to be held for a specific use and can be held for appreciation alone. The following is a list of different types of real estate interests that might not readily come to mind but are considered like-kind to any other real property interest:
- Single or multi-family rental properties
- Office buildings
- Apartment buildings
- Shopping centers
- Warehouses
- Industrial distribution properties
- Farm or ranch land
- Vacant land held for appreciation in value
- Cooperative apartments (co-ops)
- Delaware Statutory Trusts (DSTs)
- Hotels and motels
- Cell tower and billboard easements
- Conservation easements
- Lessee's interest in a 30-year lease (NOT a lessor's interest)
- Manufacturing facilities
- Interests in a contract for a deed
- Land trusts
- Growing crops
- Mineral, oil, and gas rights
- Water and timber rights
- Wind farms
- Solar arrays
Additional Types of Property Considered Real Property
The IRS has continued to clarify the rules for 1031 exchanges over the years and, in December 2020, issued new regulations that further defined real property in the Code of Federal Regulations. The clarification did not alter how all real estate is considered like-kind to all other real estate. Instead, it clarified that certain types of "inherently permanent structures" – as well as "structural components" of those inherently permanent structures – are considered part of the real estate and are therefore eligible for exchange treatment.
Regarding "inherently permanent structures" that are considered real property and thus exchangeable, the December 2020 rule clarification states:
Other inherently permanent structures. Inherently permanent structures under paragraph (a)(2)(ii) of this section include the following distinct assets, if permanently affixed: In-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; inherently permanent advertising displays for which an election under section 1033(g)(3) is in effect; inherently permanent outdoor lighting facilities; railroad tracks and signals; telephone poles; power generation and transmission facilities; permanently installed telecommunications cables; microwave transmission, cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore platforms, derricks, oil and gas storage tanks; and grain storage bins and silos . . . . See 26 CFR §1.1031(a)-3(a)(2)(ii)(C).
In CFR §1.1031(a)-3(a)(2)(iii)(B), the December 2020 rule clarification also names examples of "structural components" that are likely to qualify as real property. Those examples include:
- Walls, floors, and ceilings
- Partitions
- Doors
- Wiring
- Plumbing systems
- Central air conditioning and heating systems
- Pipes and ducts
- Elevators and escalators
- Permanent coverings of walls, floors, and ceilings
- Insulation
- Chimneys
- Fire suppression systems, including sprinkler systems and fire alarms
- Fire escapes
- Security systems
- Humidity control systems
There are several criteria named in the CFR for determining whether something is a structural component:
- The manner in which the component is affixed, or the time and expense of installing and removing the component
- Whether the component is designed to be moved, or whether circumstances indicate the component is not meant to be affixed indefinitely
- The damage that removal of the component would cause to the item itself or to the inherently permanent structure to which it is affixed
While it may seem oddly specific to note items such as walls, floors, and ceilings as qualifying for consideration in a 1031 exchange, the IRS clarifications help by giving specific criteria to guide taxpayers in determining the true value of an investment. A replacement property has to be valued either equal to or higher than the sold property to avoid a tax penalty, and even a relatively small discrepancy in valuing either property could disqualify the 1031 exchange.
Like-Kind Property Cannot Cross National Borders
While the definitions of like-kind are relatively broad, they stop at the border. The definition of real property for the purpose of 1031 exchanges is not limited to only U.S. property, but for properties to be considered like-kind, they must be on the same side of the border. For example, investors may trade foreign property for other foreign property, but not U.S. property for foreign property or vice versa. There are limited exceptions related to property in U.S. territories, but those are relatively rare.
The basis for Section 1031 tax deferral has always been continuity of investment. During most of the period when Section 1031 has been part of the tax code, exchanges could be done for assets including personal property, intangible property, and real estate. All those asset types were subject to the like-kind requirement, and like-kind meant something different for each of them. Now that only real property qualifies for 1031 exchanges, it is actually quite a bit simpler to define like-kind.