Like-kind real estate is a piece of property or land that is similar to another in nature or character.
What Is Like-Kind Real Estate?
Under Internal Revenue Service (IRS) Code 103, like-kind parcels of business or investment real estate can be exchanged for one another without requiring immediate payment of capital gains taxes. These transactions are sometimes called 1031 exchanges.
How Like-Kind Real Estate Works
According to the IRS, like-kind real estate refers to business or investment properties that are “of the same nature or character, even if they differ in grade or quality.” An example may include exchanging a hotel for an apartment building—even if one was significantly larger, of higher value, or more developed than the other; it’s still similar in nature or character.
Previously, IRS code allowed for intangible property and personal assets like cars, equipment, machinery, and other items to be considered like-kind real estate. This changed in 2018, when the Tax Cuts and Jobs Act (TCJA) went into effect.
In order to be considered like-kind real estate in the eyes of the IRS, both properties must be located in the U.S. The replacement property also must be of equal or greater value than the original piece of real estate.
Types of Like-Kind Real Estate
There aren’t many requirements when it comes to like-kind real estate. To qualify, the property needs to meet both of the following criteria:
- A physical piece of “real” property
- Intended for investment or business purposes
The size, value, level of development, and other factors don’t play a role, although the property has to be in the U.S.
Common types of like-kind real estate include:
- Apartment buildings, duplexes, triplexes, etc.
- Farms and ranches
- Malls and shopping centers
- Office buildings
- Commercial properties
- Condo units
- Industrial buildings
- Vacant land
- Self-storage facilities
Raw, unimproved land can also be considered like-kind real estate and may be exchanged for business- or investment-related properties. For real estate investors, this can be a good way to turn a non-income-producing property into an income-producing investment—or several.
Pros of Like-Kind Real Estate Exchanges
The obvious benefit of a like-kind property exchange is that it allows investors to avoid capital gains taxes. Instead, the full sales profit can be put toward a new, income-earning property—or many of them.
Since capital gains tax rates can be 15% or more of the profits, a like-kind exchange can make a big difference financially.
According to a survey by the National Association of Realtors, like-kind exchanges also help investors and developers better allocate funds, more effectively use properties, and infuse more capital into local markets. The survey of agents representing 1031 investors found that 86% of their clients invested additional money into their properties post-exchange. More than half the agents said investors also greatly improved the properties’ overall market value.
Another perk is that the IRS allows you to exchange one like-kind property for several. You can choose from:
- Three properties of any value
- Unlimited properties, as long as their combined value is equal to or less than 200% of your original property
- Unlimited properties, as long as each one is valued at 95% or more of the original property.
Cons of Like-Kind Real Estate Exchanges
On the downside, like-kind property exchanges come with a tight timeline. If you want to defer capital gains taxes in this way, you need to choose your new property within 45 days of selling the old one. Additionally, the full exchange of the properties must be complete within 180 days.
They’re also complicated transactions. The property owner must be careful not to receive even a portion of the proceeds, and they might need to use a qualified intermediary—often an accountant, attorney, or real estate broker—to manage the transaction. This could mean paying an extra fee or commission.
No capital gains taxes
Makes it easier for you to allocate funds and better use your properties
Allows you to exchange one property for many
May need a third-party intermediary
Like-kind real estate exchanges can prove to be a handy tool for real estate investors. When used properly, they can put off your tax liabilities, make purchasing new income-producing properties easier, and allow you to expand your portfolio.
Just make sure you consult a knowledgeable intermediary if you’re not familiar with these exchanges, as they can often be complex transactions. One misstep, and you could find yourself in violation of the Internal Revenue Code, which might mean a hefty penalty fee.
- Like-kind real estate exchanges allow similar properties to be exchanged with no capital gains tax paid.
- The properties need to be business or investment in nature.
- They don't have to be the exact same type of structure.
- Get professional advice because these can be complex transactions.