Like-kind real estate is a piece of property or land that is similar to another in nature or character. This designation is important to the Internal Revenue Service (IRS), because in most cases when you sell a piece of property or real estate, you will have to pay capital gains tax. In some cases, if you sell the property to purchase a second piece that is enough like the first, you can avoid that tax.
Learn more about the rules that surround these types of exchanges, and how they can work in your favor as you invest in real estate.
What Is Like-Kind Real Estate?
Under IRS Code 1031, like-kind parcels of business or investment real estate can be exchanged, one for the other, without needing prompt payment of capital gains taxes. You may also hear these types of trades referred to as "1031 exchanges."
How Do I Know Whether My Purchase Qualifies?
There aren’t many rules when it comes to what counts as like-kind real estate. In fact, it's quite simple. To qualify, the property needs to meet both of the following criteria:
- It must be a physical piece of “real” property.
- Its intent must be for the purpose of investment or business.
The size, value, level of development, and other factors don’t play a role. And since the rule falls under the purview of the U.S. tax code, the property has to be in the U.S.
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,” such as exchanging a hotel for an apartment building. This applies even if one was much larger, of higher value, or more developed than the other, so long as it is still alike in nature or character.
At first, the IRS code allowed for intangible property and personal assets to be deemed like-kind real estate. They went so far as to include items like cars, equipment, and machinery, for example. That changed in 2018, when the Tax Cuts and Jobs Act (TCJA) went into effect.
In order to count as like-kind real estate in the eyes of the IRS, both properties must be located in the U.S. The replacement piece of real estate must be of the same value as the first or greater.
Types of Like-Kind Real Estate
Some common types of like-kind real estate include:
- Apartment buildings, duplexes, triplexes, and similar properties
- Farms and ranches
- Malls and shopping centers
- Office buildings
- Commercial properties
- Condo units
- Industrial buildings
- Vacant land
- Self-storage facilities
Raw land can also count as like-kind real estate and may be exchanged for business- or investment-related properties. If you invest in real estate, this can be a good way to turn an idle piece of land into a solid investment, or many.
Pros and Cons of Like-Kind Real Estate
No capital gains taxes
Incentivizes real estate development and improves market value
Allows you to exchange one property for many
May need a third-party intermediary
The clear benefit of a like-kind exchange is that it allows you to avoid capital gains taxes when you invest in this manner. Rather than paying tax on an idle piece of land or real estate, you can put the full sales profit toward a new piece of property that earns income. The rule works in your favor even more so if you can apply the exchange toward more than one source of real estate income, such as a condo complex, or zoning for retail spaces.
For most people, capital gains are taxed at 15%. For people in the highest tax brackets, the rate goes up to 20%. Given these rates, a like-kind exchange can have a big impact on your bottom line.
Boosts Real Estate Market Value
According to a survey by the National Association of Realtors, like-kind exchanges also help investors and developers better allocate funds, make better use of land, and infuse more cash into local markets. The survey of agents found that 86% of their clients (out of a total 1,031 surveyed) put additional money into their properties after the exchange. More than half the agents said that investors also greatly improved the properties’ total market values.
Greater Income Streams
Another perk is that the IRS allows you to exchange one like-kind property for many. You can choose from:
- Three properties of any value;
- An unlimited number properties, as long as their combined value is equal to or less than 200% of your original property;
- An unlimited number of properties, as long as each one has a value of 95% or more of the original.
On the downside, like-kind property exchanges come with tight timelines. 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. The full exchange of the properties must be complete within 180 days.
High Degree of Complexity
These types of transactions can be very complex. For one, the property owner must be careful not to receive even a portion of the proceeds. They might need to use a qualified intermediary to manage the transaction. That is often an accountant, attorney, or real estate broker, but it could be any agent who knows the field. In effect, though, getting help from a third party could mean paying another fee or commission.
Whom Are Like-Kind Real Estate Exchanges For?
Like-kind real estate exchanges can prove to be a handy tool for anyone looking to invest in real estate. 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 end up in violation of the Internal Revenue Code, which might mean a hefty penalty.
- Like-kind real estate exchanges allow similar properties to be exchanged with no capital gains tax paid.
- The properties in a like-kind exchange need to be business or investment in nature, but they don't have to be the very same type of structure.
- It's advisable to seek professional help with these complex transactions if they are new to you, because the tax consequences can be severe.