Understanding Like-Kind Exchanges
Dues to changes in the Tax Cuts & Jobs Act, Like-Kind Exchanges are now generally limited to exchanges of real property.
Beginning on January 1, 2018, the new tax law now restricts like-kind exchanges to exchanges of real estate property that is held for use in a trade or business or for investment. This includes land and generally anything built on it or attached to it.
What is Like-Kind?
A like-kind exchange, also known as a 1031 Exchange, is a tax savings opportunity for real estate investors. When you sell a property, this rule allows you to defer the capital gain from the sale transaction.
You can engage in a simultaneous 1031 exchange, which happens when an investor closes the sale of their original property and also closes on the sale of the replacement property on the same day. A more likely scenario is a deferred 1031 exchange. In a deferred like-kind exchange, an investor can sell a property and they have 180 days to find the replacement property.
Interestingly, although this rule is called “like-kind” the two properties do not need to be similar. The IRS definition is that “properties are considered to be of like-kind if they’re of the same nature or character, even if they differ in grade or quality.” That means improved real property is generally of like-kind to unimproved real property. For example, an apartment building would generally be of like-kind to unimproved land. Or a ranch can be like-kind in exchange for a strip mall purchase.
What is Not Like-Kind?
One key point is that the properties should not be used for personal reasons. They must each be an investment property held for use in a trade or business. That means they cannot be a primary residence, second home, or even vacation home.
Additionally, real property in the United States is not of like-kind to real property outside the U.S.
What Changed with TCJA
Property that is no longer included in the like-kind exchange rules includes items such as machinery, equipment, vehicles, artwork, collectibles, patents, and other intellectual property. If the taxpayer disposed of the personal or intangible property on or before Dec. 31, 2017, or received replacement property on or before that date, the exchange may qualify for like-kind exchange treatment.
A 1031 Like-Kind Exchange is an advantageous tax strategy for real estate investors. However, if the property exchanged is not actually “like-kind”, the consequences are steep. The IRS will tax the full amount of the sale of the original property. If you are considering engaging in a like-kind exchange, please let your hb&k advisor know so we can ensure you correctly follow the procedures.