What Qualifies as Like-Kind Property for an Exchange?

A like-kind exchange, governed by Section 1031 of the Internal Revenue Code, is a tax strategy that allows for the deferral of capital gains taxes on the sale of an investment asset. This provision enables an investor to sell one qualifying property and acquire another without immediately recognizing a taxable gain. This mechanism is not tax avoidance, as the tax obligation is deferred rather than eliminated. By deferring the tax liability, investors can use funds that would have been paid in taxes to acquire a more valuable replacement property, potentially increasing their portfolio’s scale and maintaining the continuity of their investment.

Defining Qualifying Property

Following the Tax Cuts and Jobs Act of 2017, like-kind exchange treatment is exclusively available for real property. This means assets like machinery, equipment, and vehicles no longer qualify for tax deferral under Section 1031. The principle defining like-kind real property is that the assets must be of the same “nature or character,” not necessarily the same “grade or quality.” This flexibility allows for a wide range of possibilities, as the properties do not need to be similar in their physical attributes.

For instance, an investor could exchange an apartment building for undeveloped land, or a working ranch could be exchanged for a retail shopping center. An improved property with a building is considered like-kind to an unimproved, vacant lot. Certain types of property are explicitly excluded from being considered like-kind. These include:

• Property held primarily for sale, such as inventory for a real estate developer
• Financial instruments, including stocks, bonds, and notes
• Interests in a partnership, certificates of trust, or other securities
• A personal residence held for personal use

Core Rules for Exchanging Property

A requirement is that both the property being sold (the relinquished property) and the property being acquired (the replacement property) must be “held for productive use in a trade or business or for investment.” This means the taxpayer’s primary purpose for owning the properties must be for business operations or to generate income or appreciation. The determination of intent is based on the facts and circumstances of each case. The IRS will look at factors like the length of time the property was held and the owner’s activities related to the property.

Another rule relates to the geographic location of the properties. Real property located within the United States is not considered like-kind to real property located outside of the United States. An investor must exchange U.S. property for other U.S. property, or foreign property for other foreign property, to qualify for the tax deferral.

The Exchange Timeline and Identification Requirements

The timing of a like-kind exchange follows a strict schedule that begins when the original property is sold. The first deadline is the 45-Day Identification Period. Within 45 calendar days of transferring the relinquished property, the taxpayer must identify potential replacement properties in a signed writing delivered to a party involved in the exchange, such as the seller of the replacement property or a qualified intermediary.

The second deadline is the 180-Day Exchange Period, during which the taxpayer must receive the replacement property. This period can be cut short if the taxpayer’s tax return for the year of the sale is due before the 180 days have passed. For exchanges late in the tax year, a filing extension is often needed to use the full 180-day window. These two time periods run concurrently, and there are no extensions, making careful planning a necessity.

Within the 45-day window, taxpayers must follow one of three identification rules. The Three-Property Rule allows identifying up to three potential properties without regard to their value. The 200% Rule permits identifying any number of properties as long as their total fair market value does not exceed 200% of the relinquished property’s value.

The 95% Rule allows identifying more than three properties with a combined value over 200%, but the taxpayer must acquire at least 95% of the total fair market value of all identified properties. Failure to meet one of these rules will invalidate the exchange.

Understanding Non-Like-Kind Property Received (Boot)

When the values of the exchanged properties are not identical, other assets may be included to balance the transaction. Any cash, debt relief, or property that is not like-kind received in an exchange is known as “boot.” While the like-kind portion of the exchange remains tax-deferred, any boot received is subject to capital gains tax. The tax is recognized in the year the relinquished property is sold, though if cash boot is received in the next tax year, the gain may be reported in that year.

Boot can take several forms, including cash, non-qualifying property, or net debt relief. Net debt relief occurs when the mortgage on the replacement property is less than the mortgage that was on the relinquished property, and this difference is treated as a taxable gain. The amount of taxable gain recognized is the lesser of the total boot received or the total realized gain on the sale. For example, if a taxpayer has a realized gain of $100,000 and receives $20,000 in cash boot, they must pay tax on the $20,000. If the cash boot was $120,000, the recognized gain would be capped at the $100,000 realized gain.

To avoid boot, investors should acquire a replacement property of equal or greater value. This involves taking on an equal or greater amount of debt and reinvesting all cash proceeds. Using a qualified intermediary is standard practice to prevent the taxpayer from having constructive receipt of sale proceeds, which would be treated as taxable boot.

How to Report a Like-Kind Exchange

Taxpayers must report a like-kind exchange by filing IRS Form 8824, “Like-Kind Exchanges,” with their federal income tax return for the year the exchange occurred. This form requires detailed information about both the relinquished and replacement properties, including descriptions, transfer dates, and any relationships between the parties involved. The form guides the taxpayer through the calculations to determine the transaction’s financial outcomes.

The form is used to calculate the realized gain, which is the difference between the sale price and the adjusted basis of the property given up. It also determines the recognized gain, which is the portion of the realized gain that is taxable due to receiving boot. Finally, Form 8824 is used to calculate the basis of the new property. This new basis is important for calculating depreciation and determining the gain or loss on a future sale.