This article was reprinted with permission from the author, Brian Schmelzlen, practicing CPA/Tax Attorney at Reid, Sahm, Isaacs & Schmelzlen LLP.
As we discussed in the last blog post, a 1031 exchange is a tax-deferred, like-kind exchange of property held for productive use or investment for another property held for productive use or investment. In English, it allows you to trade one property for another property without paying income taxes at that time.
As you can imagine, this is a major benefit to taxpayers because it means that you can defer paying thousands of dollars (or far more) in taxes for years. Obviously, such a beneficial tax code provision is going to have very strict requirements that must be met in order to utilize it.
The first requirement is that the property that you are disposing of must have been held for productive use in a trade or business or for investment. This means that it cannot be personal use property, such as your principal residence or a vacation home.
The second requirement is that the property that you are acquiring must be used either in a trade or business or for investment. How the other party used the property is irrelevant, the test is how you will use the property. The basic idea is that if you are going to be allowed to defer taxes from the “sale” of the relinquished property, you have to use the replacement property in a similar manner.
The next requirement is that the property cannot be: inventory, stock, bonds, notes or other evidence of indebtedness, interests in a partnership, certificates of trusts or beneficial interests, or choses in action.
Finally, the replacement property must be of a “like kind” to the property relinquished. All real estate located in the United States, whether it is improved or unimproved, is considered to be like-kind to other real estate located in the United States. However, real estate located in the United States is not like-kind to real estate outside of the United States.
Unlike with real estate, not all personal property (e.g., equipment, furniture, etc.) is considered to be like-kind to other personal property. In order to be like-kind, the personal property must be in the same asset class (and if livestock, must be the same gender). In addition, as with real estate, personal property located in the United States is not like-kind to personal property outside of the United States.
There are additional timing requirements that must be met if the property exchange does not occur simultaneously, but we will discuss that further in a future blog post.