Like Kind Exchange Requirements
As with every other section of the tax code, Section 1031 like kind exchange rules abound. Complying with Section 1031 is not unlike jumping through a series of bureaucratic hoops. In a very real sense, when you approach someone to assist with a 1031, what sets a good counselor apart is his or her understanding of the applicable rules.
In the past, for instance, we’ve discussed the identification requirements of 1031. We talked about how taxpayers have to comply with one of three rules which identifying potential replacement property. We’ve also written about the 180 days to identify replacement property. If a taxpayer fails to comply with even one of the essential requirements of 1031, then the transaction will collapse. A collapsed exchanged will result in taxation at all applicable levels, as well as interest and penalties in many cases. This is why it’s often advisable to obtain a competent tax attorney to provide additional counsel even when a taxpayer hires a reputable qualified intermediary.
What is a Like Kind Exchange?
In this post, we’d like to explore the like-kind requirement of 1031 in detail. As we’ll discuss, this is one of the primary requirements of Section 1031. The like-kind requirement is not too difficult to satisfy. For real estate, the phrase “like-kind” has a broad interpretation. Raw land, for instance, is generally like-kind to land with a structure. Ultimately, as we’ll see, what qualifies as real estate for a tax deferred exchange depends on how the property in question is classified under local law.
A Like Kind Exchange Has Four Main Requirements
IRC Section 1031 has four primary requirements (or elements) which must be met in all cases for tax deferment. These requirements come straight from the main paragraph of the tax code. These requirements are as follows: (1) there must be an actual exchange, (2) the exchange must involve like-kind property, (3) the property must be eligible, and (4) the property must be held for a trade or business or investment purposes.
A Case by Case Analysis
The code itself doesn’t list these four requirements in this sequential fashion, but each of these requirements has been identified by the courts. The like-kind requirement is similar to the “held for” requirement in the sense that it involves a case-by-case analysis. Although what is like-kind is generally understandable and there are rarely disputes, there can be gray areas. The main point to understand here is that the like kind exchange requirement applies to every 1031 transaction. If a transaction doesn’t meet the like kind requirement, the transaction will fail.
Like-Kind Exchanges Enjoy a Broad Interpretation for Real Estate
As alluded to above, there is a certain level of grayness surrounding the like kind exchange requirement. Therefore, it’s not always possible to predict whether a certain property will satisfy the exchange properties requirement in a given instance. However, the good news for investors is that this requirement enjoys a wide definition of real estate. For a given property to be like kind to another, there doesn’t need to be a high degree of superficial resemblance. For instance, courts have held that a leasehold interest of at least 30 years is like kind to a fee interest. This means that a person doesn’t even have to “own” real estate to satisfy the like kind requirement. What’s more, unimproved land is generally like kind to improved land. Accordingly, a plat of raw land is like kind to a commercial building or rental property.
1031 Includes Property Rights
The broad interpretation of the like-kind requirement even includes rights to certain property. For instance, oil rights and mineral rights are like kind to real estate in certain cases. In other cases, easements are like kind to a fee interest in real estate. Fractional interests are also considered like kind to whole interests. For instance, fractional interests in a tenants-in-common property or Delaware Statutory Trust are also like kind. The bottom line is that fulfilling the like kind requirement is fairly simple. However, if a taxpayer is preparing to acquire an unusual type of real estate, or something not previously ruled on by a court, it’s strongly advised to seek legal counsel.
Local Law Defines the Definition of Real Estate
The other important point to consider is that, ultimately, local law classifications determine whether the like kind requirement is met. In the Treasury Regulations to the tax code, we see that there are certain exclusions from the like kind definition. Interests in a partnership are an exclusion, for instance. This means you can’t sell real estate to a partnership owning real estate. That’s why such entities often have to be dissolved in order to perform a Sec. 1031 exchange at a later point in time. But one of the key things that will be considered, if there is a dispute about the status of a given property, is its classification under local law. If certain property, such as water rights or air rights, is classified as real estate under local law, then it will typically hold up under judicial scrutiny.
The Devil is in the Details
The like kind requirement of the investment property is straightforward in most cases, but can be tricky depending on the specifics. If you are unsure about whether a relinquished property will be like kind to your replacement property, you may want to consult with an attorney. If the IRS sees room for debate, they may bring you to court in an attempt to collapse the transaction. It’s better to consult with an attorney than risk going to court and dealing with pesky litigation.
Call Us For More Detail
If you”re an real estate investor, our firm of Mackay, Caswell & Callahan, P.C., is thoroughly familiar with the provisions of Section 1031. We offer counsel when needed, whether regarding when a property is sold, or proceeds from the sale. Given the stakes involved, you shouldn’t procure just anyone to give you counsel. If you have an upcoming exchange, reach out to one of our top New York City tax attorneys for assistance today.
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