Learn
A little clarity for your next decision.
Loading your learning library…
Investor WorkspaceWelcome, there!Log Out
Investor WorkspaceA little clarity for your next decision.
By Jerry Baker
Like-kind property for a 1031 exchange is qualifying real property of the same nature or character, not necessarily the same building type or quality. Business or investment real estate can often be exchanged across property types, but personal-use property, ordinary company shares, and many other financial interests do not fit the rule. You must check the actual legal interest, intended use, location, and exchange process before treating a proposed purchase as eligible. [1] [2]
The Treasury rule focuses on nature or character, not grade or quality. It states that improved and unimproved real estate can be like kind. It also gives an example of city real estate exchanged for a ranch or farm. [2]
That is a broader test than matching a rental house with another rental house. A commercial building and investment land may fit the real-property comparison even though their rents, upkeep, and business plans differ.
The broad rule does not let every asset linked to land qualify. A mortgage note, shares in a real estate company, and a deed to a building are different legal interests. They can all be tied to real estate but have different tax treatment.
Nor does like kind mean equal value. A value or funding shortfall can cause taxable gain even when both properties are like kind. First classify the property. Then calculate the exchange result.
Start by asking whether the asset is real property for Section 1031. Next ask whether the old property was held, and the new property will be held, for investment or business use. Then compare the nature of the interests and their location. Finally, check that the transaction follows the exchange rules.
Each test answers a different question. A personal home is real property, but personal use is a problem. A share of a company may be held for investment, but that does not turn the share into direct ownership of its buildings.
A qualifying rental building bought too late may fail the deferred-exchange timing test. A qualifying building purchased after you receive all the sale cash may be part of an ordinary sale and purchase rather than a deferred exchange. [3]
Ask advisers to identify which test a conclusion addresses. “It is real estate” is not a complete explanation of why the whole exchange works.
The real-property rule includes land and improvements to land. It defines improvements to include buildings, other inherently permanent structures, and qualifying structural components. Houses, apartments, stores, offices, warehouses, and other permanently affixed buildings fall within its examples. [4]
Unimproved land does not need current rental income to be an investment. The like-kind rule includes real estate held for future use or growth in value under its stated investment facts. That differs from property held mainly for sale by a dealer. [2]
Vacancy does not by itself answer the question either. A vacant building may still be held for investment. Review what the owner is doing with it and why, rather than assuming occupied equals eligible and vacant equals ineligible.
The new property need not preserve the old business model. You can change your exposure while still meeting the tax classification rules. Whether that change is a wise investment remains a separate decision.
A transaction can include land, a building, and many items inside it. The real-property rule looks at each distinct asset. It gives tests for fixed structures and their parts. How an asset is attached, whether it is meant to remain, and the harm and cost of removal can matter. [4]
Built-in wiring, plumbing, heating, and fire protection can be structural parts under the rule. Their function and connection to the building matter. A box placed in a room does not become real property merely because the room is real estate.
Avoid a blanket statement that all machinery qualifies or none does. State or local real-property treatment and the federal tests can affect particular assets. The regulation includes detailed examples that depend on their stated facts.
Get a list of included assets before dividing the price among them. Counsel and the tax preparer need to know what is actually transferred, not just the address on the contract.
The regulation generally includes unsevered natural products of land, such as growing plants and timber, mines, wells, and natural deposits. Once these products are cut, extracted, or removed, they are no longer real property under that rule. [4]
That distinction can matter for a farm, timber property, or mineral transaction. The land, the unsevered resource, harvested goods, equipment, and contractual rights may need separate analysis.
For example, keeping harvested goods in a building does not turn the goods back into real property. The regulation's fruit example makes that distinction. The place an item is stored is not the same as the nature of the item.
Do not extend this basic rule into a claim that every oil, gas, timber, or royalty investment qualifies. The actual interest, duration, rights, and entity structure need review. A fund that invests in such assets is not automatically the same thing as owning the assets.
The regulation lists several intangible real-property interests. They include fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, and land development rights. It also includes certain specifically described stock interests. [4]
Being listed as real property is one step. The proposed exchange must still be like kind, held for the required purpose, and otherwise valid. A short or limited right should not be assumed equivalent to full ownership without further review.
A license solely to use, enjoy, or occupy real property may fit the rule. It must be in the nature of a leasehold, easement, or similar right. A license to operate a business on the property is treated differently.
Read the right itself. What can the holder do? For how long? Can it be sold on its own? Does it end when a business closes? Those terms can be more important than the document's heading.
The like-kind regulation gives an example of a leasehold with 30 years or more remaining exchanged for real estate. That is a useful rule to know, but it is not permission to treat every commercial lease as equal to fee ownership. [2]
A lease with five years left and an informal hope of renewal is not the same fact pattern. If renewal rights matter, have counsel review whether and how they count. Do not add years based on a landlord's verbal assurance.
Also separate the tenant's leasehold from the owner's fee interest subject to a tenant lease. Buying a building rented to a tenant is not the same as buying only the tenant's remaining right to occupy it.
A short explanation of who owns the land, who owns any improvements, and who holds the lease can avoid a major misunderstanding before price negotiations begin.
The real-property rule excludes ordinary stocks, bonds, notes, and other securities or debt interests. It also excludes partnership interests, subject to the stated exception, and certain other rights. These exclusions apply even if state or local law uses a different label. [4]
Shares in a conventional REIT are not direct replacement real property merely because the REIT owns buildings. A note secured by a warehouse is still a debt claim rather than fee ownership of the warehouse.
Be careful with broad claims that “all stock is excluded,” too. The regulation specifically addresses cooperative housing stock and qualifying shares in certain ditch, reservoir, or irrigation companies. Those narrow categories do not make ordinary corporate shares eligible.
Ask exactly what the purchase documents transfer. Being exposed to real estate is not the same as owning it for tax purposes. A product can be a valid real estate investment yet fail to qualify as a direct 1031 replacement.
A partnership can own real estate and make its own exchange. That does not generally let an individual partner exchange a partnership interest for a building. The partner owns an entity interest; the partnership owns the property.
Section 1031 contains a narrow rule for a partnership with a valid election under Section 761(a) to be excluded from all of subchapter K. The statute treats that interest as an interest in the assets for this purpose. Do not assume an ordinary real estate partnership has made or qualifies for that election. [1]
If owners want different outcomes, changing from an entity to direct co-ownership raises further questions. The ownership history, investment intent, loan, contracts, and timing all need review. A new deed just before closing is not a universal cure.
Resolve who is exchanging before choosing the replacement. A tax-qualified asset does not solve a mismatch between the taxpayer selling and the taxpayer buying.
Revenue Ruling 2004-86 addresses a trust with specific powers and limits. Under its facts, owners were treated as owning fractional interests in the underlying real estate for federal tax purposes. The IRS therefore allowed exchange treatment if the other requirements were met. [5]
The result did not come from the Delaware filing alone. The ruling examines whether the trust could vary its investments and whether owners were treated as owning its assets. Additional management powers could produce a different entity classification.
Review the actual trust agreement, tax opinion, and offering terms. The words “DST” or “1031” in a name do not replace that review. A securities-law treatment and a federal tax ownership treatment can address different questions.
Also review possible changes during the investment. A later conversion or contribution can affect what you own and the options for another exchange. Initial eligibility is not a promise of a lifelong path to deferral.
A dwelling used only as a personal residence does not qualify under the investment or business-use requirement. Expecting the house to rise in value does not, by itself, turn that personal use into investment use. [6]
Mixed use is more complex. A home with a genuine rental portion, or a vacation property with rentals and personal stays, needs a factual review. Keep records of actual use rather than relying on a listing description.
Offering a property for rent is not the same as renting it. A family member’s stay may not be treated like a stay by an unrelated tenant. The applicable personal-use rules can count more days than the owner expects.
Tell the tax adviser about planned personal use of the replacement before buying. An undisclosed plan to move in can be important even when the property could physically be rented.
Revenue Procedure 2008-16 provides a limited safe harbor for dwelling units. For the old dwelling, it requires at least 24 months of ownership immediately before the exchange. For the new dwelling, it requires at least 24 months immediately after. [6]
Within each relevant 12-month period, the dwelling must be rented to others at a fair rental for at least 14 days. Personal use cannot exceed the greater of 14 days or 10% of the days rented at a fair rental. The procedure defines those periods and refers to specific rules for personal use.
With 200 fair-rental days in one relevant period, the personal-use ceiling under that formula is 20 days. With 100 rental days, it is 14 days, not 10. Those examples assume the other safe-harbor conditions are met.
This safe harbor addresses qualifying use of a dwelling. It does not waive the other exchange requirements or create a universal two-year holding rule for every kind of property. A case outside it needs its own analysis.
Section 1031 excludes real property held primarily for sale. A developer's inventory and a long-term rental may be the same kind of building but held for different purposes. The owner's actual facts matter. [1]
Ask why the asset was acquired, what was done with it, how it was marketed, and why it is being sold. Records made while you owned the asset can carry more weight than a new label added just before the exchange.
There is no general promise that holding any property for a fixed number of months makes it investment property. Nor should a quick sale after an unexpected event be judged from the calendar alone. Get advice based on the full record.
For replacement property, the intended holding purpose matters at acquisition. A planned immediate resale should not be disguised as long-term investment simply to fit the exchange paperwork.
Section 1031 expressly states that real property in the United States and real property outside the United States are not of like kind. An exchange of a U.S. rental for a foreign rental cannot avoid that rule merely because both properties serve the same use. [1]
The restriction is about where the real property is located, not just where the owner or investment manager lives. Review the underlying property when an entity, trust, or portfolio has interests in more than one country.
An exchange involving foreign properties needs separate review of the interests, local law, federal tax treatment, and other requirements. Do not infer from the U.S.-versus-foreign rule that every foreign-to-foreign exchange necessarily qualifies.
A move between U.S. states is a different question. Federal like-kind treatment does not settle state filing, tracking, or tax duties. Have the adviser address the states connected to both properties and the owner.
The identification regulation can treat certain incidental property as part of a larger item when the stated conditions are met, including the 15% value test. That is an identification rule. It does not make otherwise nonqualifying personal property tax-free. [3]
Consider a hypothetical purchase of $1 million of qualifying real estate plus $80,000 of furniture that is assumed to be non-real property. The furniture is 8% of the real-estate value. Even if the incidental identification conditions apply, the furniture's tax treatment still needs a separate calculation.
Do not treat 15% as a budget for free cash, equipment, or furnishings. Divide the price among the assets on a basis you can support. The same documents may affect gain, depreciation, and the buyer's future basis.
The real-property regulation states that its definition applies for Section 1031 and does not control every other tax rule. An asset can be real property for the exchange while Section 1245 or Section 1250 still affects the gain calculation. [4]
This matters when a building contains assets with different depreciation histories. A cost-segregation study may have assigned some items to shorter recovery periods. The exchange analysis must not simply ignore those items because the sale contract calls the whole asset real estate.
Give the CPA the full depreciation schedule, prior exchange basis records, and asset allocations. A statement that both properties are like kind does not by itself establish zero recognized gain or zero current tax.
For each asset or interest, record what it is and why it is real property. Explain why it is like kind to what you give up. Show how the facts support the holding purpose. Note any separate personal property or financial interest.
Then verify identification, receipt dates, money flow, related-party facts, and the taxpayer making the exchange. An asset can pass the property test while the process fails. Neither review replaces the other.
The useful answer is not a slogan such as “real estate for real estate.” It is a clear explanation of the rights being transferred and the rules those rights satisfy. That explanation should survive a close reading of the final documents.
Save the version of each deed, lease, or trust document used for that review. If a term changes before closing, ask whether the conclusion still holds. A sound answer based on an old draft may no longer fit the rights you will receive.
It can, if the actual interests are qualifying like-kind real property held for the required purposes and the transaction satisfies the other rules. Matching the old building type is not generally required. [1] [2]
Yes, improved and unimproved real estate can be like kind. The land must be held for investment or business use, rather than personal use or primarily for sale, and the full exchange must qualify. [2]
Ordinary REIT shares are company stock, not direct replacement real estate. A separate transaction under another tax provision should not be described as a direct Section 1031 exchange into those shares. [4]
No. The regulation's example concerns a leasehold with at least 30 years remaining exchanged for real estate. A landlord's ownership subject to a lease is a different interest. Review the actual rights and remaining term. [2]
Expected appreciation alone does not turn personal use into investment use. Review actual rental and personal use, including whether the dwelling safe harbor applies. All other exchange requirements remain relevant. [6]
No general two-year rule makes every property eligible. Specific provisions have specific periods, including the dwelling safe harbor and related-party rules. Ordinary investment intent depends on the relevant facts. [1] [6]
U.S. and foreign real property are expressly not like kind under Section 1031. Similar use, price, or building type does not remove that restriction. [1]
No. Cash, debt relief, other property, recapture rules, or a failed exchange requirement can affect the tax result. Classification is one part of the analysis, not the entire calculation. [1] [4]
Educational information, not an offer or a personal tax, legal, or investment recommendation. Examples are hypothetical and omit stated adjustments. Tax treatment depends on your facts and current law. Review your transaction with your CPA, attorney, and qualified intermediary. Real estate investments can lose value and may be illiquid.
Enter your approved email to explore investments, save your shortlist, and keep learning.