Real estate transactions can be costly, so you might hesitate to look for a new property unless you are sure you can obtain it without depleting your financial resources. Fortunately, the U.S. tax code can make things easier through a like-kind exchange.
Through Section 1031 of the Internal Revenue Code, people who want to buy property can defer paying capital gains taxes on the new property.
A swap instead of a purchase
To take an example, an investor owns a rental house and wants to exchange it for an apartment building. Rather than selling the house outright, the investor finds a buyer for the house who is willing to exchange it for an apartment building that investor wants to acquire. Through a like-kind exchange, the house swaps for the apartment building with no cash involved.
To qualify, the investor must identify the replacement property within 45 days of closing on the sale of the old house, and acquire the new apartment building within 180 days. This allows the investor to defer capital gains taxes normally due on the sale of the rental house. This enables the investor to reinvest all of the equity into the replacement property.
Properties that qualify for like-kind exchange
A “like-kind” property refers to the nature or character of the property, not its quality or grade. For example, a rental house exchanged for an apartment building would qualify. The properties do not need to be identical, just of “like-kind.”
The most common like-kind exchanges involve real estate. Vacant land can exchange for improved real estate. Owners can swap commercial property for residential property. Other eligible property types include pipelines, mineral rights, grazing rights and spectrum licenses. However, personal property such as cars, stocks, bonds, inventory and artwork do not qualify for like-kind exchanges.
Section 1031 like-kind exchanges offer a powerful tax advantage for real estate investors. However, they involve various legal complexities that require special planning to pull off, so evaluate opportunities with care.