Aug, 2009

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Many people hear the term "like-kind" when they're talking about Section 1031 exchanges and they start to panic. Please, relax! I've got an easy way for you to figure out whether two properties are like-kind to each other for purposes of exchanging. Corn farm HDR

First of all, a caveat... the easy way only applies to real estate exchanges. I'll talk more about other types of exchanges later, but suffice it to say that it is more difficult to determine like-kind status in those exchanges. With real estate, however, it's pretty simple. I've heard other exchange people say, "All real estate is like-kind to all real estate." In my opinion, that simplifies things a little too much, and I'll give you an example why later. 

For the meantime, here is the secret to determining whether a piece of real estate is like-kind to another piece of real estate within the exchange context: Ask yourself (or your client, if you are a real estate, tax, or legal professional) these questions:

  1. (Regarding the property being sold) Did own this property with the intention of holding it as an investment or using it in the pursuit of my business or trade?
  2. (Regarding the property being purchased) Do I intend to hold this property as an investment or use it in the pursuit of my business or trade?

If you (or your client) can answer, "Yes" to both of those questions and can substantiate his or her answer, the two properties are like-kind for purposes of exchanging.

Is a farm like-kind to an apartment building? In the vast majority of cases, the answer is yes. Is a rental house like-kind to a small-town office building? In the vast majority of cases, the answer is yes. Is a single-family home that was purchased with the intention of fixing up and reselling like-kind to a duplex? AHA! Here's an example of why all real estate is NOT like-kind to all real estate. Clearly the single-family home being rehabbed is real estate, but the IRS considers this property to be inventory in a business and not something that was purchased with the intention of being held for investment. I can hear you arguing "This was an investment!! I invested my hard-earned dollars to buy the house and now I'm investing my hard-earned dollars to fix up the place. Why doesn't that make it an investment??!?" A solid argument, I will admit, but one which you will lose when you face the IRS examiner.

It all comes down to the intent. Did you buy the property you are now selling with the intention of holding it as an investment? No, your intention was to fix it up and sell it. So it does not qualify for a Section 1031 exchange.

I promised to talk about non-real-estate exchanges, but this has already gotten a little lengthy. Let me bring this to a close by saying that the exchanges of business assets, etc. require a much higher standard when determining like-kind status. The IRS uses Asset Classes and Product Classes to determine whether two items are like-kind. The items must fall within the same class to qualify. I will write an article on business asset exchanges in the future and address this issue more thoroughly. For now, just remember the two questions and you will be set!