Real estate investors continually look for strategies to maximize after-tax returns and preserve capital. One of the most effective tools available to achieve these ends is the Section 1031 like-kind exchange. This provision of the Internal Revenue Code allows an investor to sell investment or business-use real property and reinvest the proceeds into qualifying replacement property while deferring recognition of capital gains.

This article is the first in a three-part series providing an overview of the basic concepts of a like-kind exchange, with this introductory piece discussing the appeal of a 1031 exchange and the property types that qualify.

What is a 1031 Exchange?

A “1031 exchange,” named after Section 1031 of the Internal Revenue Code, permits real estate investors to sell investment or business-use property and reinvest the proceeds into like-kind property while deferring—not eliminating—capital gains taxes.

The benefits of a 1031 exchange extend beyond simple tax deferral: by avoiding immediate tax liability, investors can leverage their full sale proceeds to acquire higher-value properties, diversify their portfolios, consolidate multiple properties into one, or divide a single property into several assets. This increased purchasing power can compound over time, allowing investors to build substantially larger real estate portfolios than would otherwise be possible if capital gains taxes were paid with each transaction.

Types of Property That Qualify

Understanding what qualifies as “like-kind” property is essential to structuring a compliant 1031 exchange. Under current law, effective January 1, 2018, only real property qualifies for Section 1031 treatment.

The good news for real estate investors is that the definition of “like-kind” is remarkably broad. For real property, it refers to the nature or character of the property, not its quality, grade, or specific use. In practice, almost all U.S. real property held for investment or business use is considered like-kind to other U.S. real property held for investment or business use. An investor can exchange raw land for an apartment building, a commercial office building for a retail center, or a rental house for industrial property - the specific type of real estate does not matter as long as both properties are held for investment or business purposes.

Qualified property types include:

• Commercial buildings

• Residential rental properties

• Raw or undeveloped land

• Industrial facilities

• Retail centers

• Multi-family apartment complexes

• Agricultural property

• Long-term leasehold interests (typically 30 years or more)

Non-qualified property types include:

• Primary residences

• Property held primarily for resale (such as fix-and-flip properties)

• Inventory or stock in trade

• Stocks, bonds, notes, or other securities (including REIT shares)

• Partnership interests

• Certificates of trust or beneficial interests (such as REITs)

• Foreign property (U.S. property must be exchanged for U.S. property)

Vacation or second homes can present more complex issues. Property used primarily for personal enjoyment does not qualify for 1031 exchange treatment. However, in certain circumstances, a vacation property that is genuinely held for investment and made available for rent may qualify. Revenue Procedure 2008-16 provides a “safe harbor” based on specific rental and personal use patterns. Investors considering exchanges involving vacation or mixed-use property should obtain tax advice tailored to their specific facts.

Summary

At its core, a Section 1031 exchange allows investors to sell investment or business-use real property and reinvest in other qualifying real property without immediate recognition of gain. The definition of like-kind real property is broad, but there are important exclusions and nuances, particularly for personal-use and foreign property.

The next article in this series will address the structure and mechanics of a 1031 exchange, including the parties involved, the role of the qualified intermediary, and the critical statutory timelines that govern identification and closing.

For more information about 1031 exchanges or to discuss your specific real estate investment goals, contact Stuart F. Wallace at (912) 236-0261 or the HunterMaclean Real Estate team.