Internal Revenue Code Section 1031 applies only to “property held for productive use in a trade or business or for investment”. (IRC section 1031(a)(1)). It allows for the deferral of capital gain tax if such property is exchanged solely for property of “like-kind”. Contrary to what many people believe, “like-kind” does not mean that an investor must, for example, exchange land for land, or a duplex for a duplex. In the context of real estate, like-kind exchanges are valid between and among several different types of investment property, including bare land, commercial property, industrial buildings, retail stores, apartments, duplexes-even leasehold interests exceeding 30 years and certain oil and gas interests.
FLEXIBILITY AND DIVERSIFICATION
The liberal definition of “like-kind’ in real property exchanges means significant advantages for the investor who elects to perform a 1031 exchange. For example, when raw land is traded for a small retail center, capital gain taxes can be avoided, and the investor will also reap the benefits of owning a property that will generate increased cash flow. Another advantage in this example is that depreciation can be taken on the retail center, an option that was not available when the investor held raw land.
The broad definition of like-kind property may also give the 1031 investor added flexibility. For example, if real property is owned as a tenancy in common interest with others, investors may exchange their undivided interests in the relinquished property for fee interests in separate replacement properties.
Similarly, property owners who are tired of the time consuming management of an apartment building, can exchange into a low maintenance, single tenant leased investment that offers a good return and potential for appreciation.
In accordance with section 1031, like-kind property does not include stock in trade or other property held primarily for sale; stocks, bonds or notes; other securities or evidence of indebtedness or interest; interests in a partnership; certificates of trust or beneficial interest, or chooses in actions. An investor’s primary residence, personal property, cash and foreign property are also not like kind to real property held for investment.
The 1031 exchange offers the real estate owner a host of several other benefits, not to mention the tremendous increase in purchasing power from not having to pay the IRS or Franchise Tax Board! Please call us if you have further questions, and be sure to consult with your tax or legal advisor about your specific circumstances.