The Definition of Like-Kind Property in a 1031 Exchange
Successful investors in any industry understand how to legally apply tax breaks afforded by the IRS to help ensure that they have more money in their pocket at the end of the year. For real estate investors, one of the most effective tax breaks available is a 1031 exchange. This exchange, which helps investors offset capital gains generated by an investment property helps minimize the amount of capital gains taxes that an investor must make. Continue reading to get a better understanding of what a 1031 exchange is and how you can use it to maximize your annual profits.
What is a 1031 Exchange?
A 1031 exchange, also referred to as a “like-kind exchange” is a tool that allows real estate investors to exchange an investment property for another property that is considered to be of “like-kind.” This break gets its name from its position in the IRS tax code, in which it is found in Section 1031. When an investor exchanges one investment property for a like-kind property, he or she is not responsible for the capital gains taxes associated with the property that’s been traded. However, there are many moving parts in a 1031 exchange, and it’s vital that you understand how to use this tax tool legally.
What is Like-Kind Property?
According to Federal Tax Code, like-kind property is defined as “any property held for investment, trade, or business purposes under Section 1031 of the Federal Tax Code.” In layman’s terms, like-kind property simply refers to two properties that are held for business or investment purposes. One of the first things that this definition excludes is residential properties. This means that you cannot exchange your primary residence for another home in order to avoid taxes. In order to classify as a like-kind property, the subject properties must be held for investment or business purposes only.
Examples of Like-Kind Property
Many investors incorrectly believe that like-kind properties must be of similar size or type in order to qualify. That is simply not the case. The following list provides some examples of properties that qualify for a 1031 exchange.
- You can exchange a hotel for a shopping center
- You can exchange a piece of vacant land for a medical facility
- You can exchange an apartment complex for a factory or other industrial building
- You can exchange a condominium for a single-family rental property
- You can exchange an apartment complex for an office building
These exchanges do not take the size of the facility or its original purpose into consideration. Instead, they are made eligible for a 1031 exchange based solely on the fact that they are properties that are held for investment or business purposes.
Knowing how to effectively use tax breaks such as 1031 exchange is one of the most important tools that any real estate investor has at his or her disposal. Being able to defer capital gains taxes ensures that you’re getting the most out of your portfolio. If you want to make sure that your personal net worth and your investment portfolio are maximized for your heirs, knowing how to use a 1031 exchange is a must.
As is the case with all tax breaks, it’s important that you consult with a tax professional, real estate attorney or other industry professional to be sure that you are operating within the confines of the law. Effectively applying tax breaks is a great way to secure your own financial future and the financial security of your loved ones.