Navigating the world of real estate investments can be complex, especially when dealing with tax deferral strategies like 1031 exchanges. Named after Section 1031 of the Internal Revenue Service’s (IRS) tax code, a 1031 exchange allows investors to defer capital gains taxes on the sale of their property, provided they reinvest the proceeds into another “like-kind” property. In many cases, using a 1031 exchange can significantly boost your available investment capital, let you diversify your portfolio, or allow you to relocate without an immediate tax burden. If you want to fully leverage your exchange options, it’s important to understand how the IRS defines real property, like-kind property, and what qualifies as an investment. Let’s dive into these key concepts.

What is Real Property?

Real property refers to land and anything permanently attached to it. This includes not only the land itself but also any structures, buildings, and fixtures. Understanding which assets fit under this definition is essential for 1031 exchanges, as only real property qualifies for tax deferral under this section of the IRS code.

The definition of real property has been a moving target for the IRS over the years.  In 2020, the Service issued the Real Property Regulations to offer a comprehensive definition that included both tangible assets and intangible assets. 

Components of Real Property:

• Land: The most straightforward example of real property, including the soil and any natural resources found on it.
• Buildings: Residential homes, commercial buildings, industrial warehouses, and apartment complexes all fall under this category.
• Improvements: Any enhancements made to the land or buildings, such as roads, fences, and landscaping.
• Fixtures: Items permanently attached to the buildings, like plumbing, electrical systems, and built-in cabinetry.

The permanence and immovability of these components are what distinguish real property from personal property, which includes items like vehicles, furniture, and equipment that are not permanently attached to the land or buildings.

It’s also important to point out that real property does not include an ownership interest in a business entity, such as an LLC or corporation. Buying shares in a real estate investment trust (REIT), for example, doesn’t count as acquiring real property; the IRS takes the position that equity in a legal entity is distinct from owning the underlying real estate. 

Note on State and Local Law: Even though the IRS offered a comprehensive definition of real property in 2020, it still offers the so-called “state and local law test” as an alternative means to determine if an asset qualifies for 1031 exchange treatment.  Under this test, any asset classified as real property under the laws of the jurisdiction where it’s located will generally be considered valid for 1031 exchange purposes. However, the IRS did leave itself the room to potentially disagree with state or local laws, suggesting in the preamble to the 2020 Real Property Regulations that state and local laws would only be “one factor” considered. 

What is Like-Kind Property?

This is a very important concept to understand, and it is a source of confusion for many investors who undertake a 1031 exchange. For a successful 1031 exchange, the properties involved must be considered like-kind to each other. According to the IRS, like-kind properties are those that are of the same nature, character, or class. This does not mean they must be identical in use or value, but they must share the same fundamental characteristics.

Examples of Like-Kind Properties:

• Unimproved land for improved land with structure: Swapping raw land for a multifamily complex. 
• Residential property for commercial property: Trading out of a single-family rental into a retail commercial center.
• Single property for multiple properties: Exchanging from one investment property into several distinct investment properties (or vice versa).
• Mixed-use property for single-use property: Trading out of property held for investment that includes a personal residence for a separate property that will only be held for investment (the residence sale will be treated separately under IRC § 121).
• A tenancy-in-common interest for a fee interest: Exchange out of a partial ownership TIC interest (e.g. a 33.3% interest) and into real property where you own 100% of the fee interest.
• Mineral rights held as real property for multifamily residential property: Swapping from a qualifying oil or gas mineral lease into a quad-plex held for investment. Oil and gas interests involve a myriad of additional factors to consider and state-specific rules, so please consult a tax or legal advisor familiar with oil and gas interests. 

The list above could go on and on.  While there are important exceptions, from a practical standpoint, most real property is considered like-kind to most other real property. The key here is flexibility. The IRS provides a broad interpretation of like-kind, allowing investors significant leeway in the types of properties they can exchange. This flexibility is a major advantage, enabling investors to diversify their portfolios without incurring immediate tax liabilities.

What Qualifies as an Investment?

To qualify for a 1031 exchange,  both the property sold (relinquished property) and property acquired (replacement property) must be held “for productive use in a trade or business or for investment” under IRC § 1031(a)(1).  This is often referred to as the “qualified use” or “held for” test. Personal residences, for instance, do not qualify because they are not held for investment.

Investment Property Criteria:

• Intent to Hold: The property must be acquired with the intention of holding it for productive use in a trade or business or for investment. It is ideal if the investor can somehow document this intention, if possible, and their actions should reflect and support the intent to hold the real property for investment purposes.
• Holding Period: While the IRS does not specify a minimum holding period, properties held for less than a year may be scrutinized to determine if they were genuinely intended for investment. A common practice is to hold the property for at least two years to substantiate the investment intent.
• Income Generation: Properties that generate rental income, such as apartment buildings, office spaces, or rental homes, almost certainly meet the investment criteria. Similarly, properties used in a business, like a warehouse or retail space, should qualify. Note that if the investor intends to flip or quickly resell such property, that intention may overshadow the fact that it generates income.  
• Capital Appreciation: Land or property held for future capital appreciation can also qualify as an investment property. Investors often buy undeveloped land or underdeveloped properties with the expectation that they will increase in value over time.  In other words, real property does not have to generate rental or other income to qualify as an investment. 

Understanding the 1031 Exchange Process

The 1031 exchange process involves many steps, and proper adherence to IRS guidelines is a critical component for reducing the risk of non-compliance.

In the world of 1031 exchanges, the IRS creates specific guidelines, known as Safe Harbors, to help taxpayers navigate the complexities of the process. The Safe Harbor guidelines outline acceptable methods for executing a like-kind exchange, effectively providing clear roadmaps for compliance.  While the use of Safe Harbor structures in a 1031 is not technically mandatory, almost all 1031 exchanges in the modern age use them. To ignore the Safe Harbor roadmap is to leave yourself open to audit risk, tax risk, and potential penalty. 

The most commonly used Safe Harbor is the Qualified Intermediary (QI) Safe Harbor, which requires that the investor seeking a 1031 exchange engages an independent third party to act as QI to facilitate the entire exchange process. The following steps are outlined with this Safe Harbor in mind. 

1. Identify a Qualified Intermediary (QI): The IRS mandates that in almost all 1031 exchanges, a neutral third party, known as a Qualified Intermediary, is needed to facilitate the exchange and to escrow the transaction proceeds so that the investor does not have access to, touch, or have constructive receipt of the transaction proceeds. The QI needs to manage the proceeds from the sale of the relinquished property (usually by depositing those funds in a reputable Federally or State Chartered bank that provides FDIC insurance).  The QI  then uses those segregated, escrowed proceeds to purchase the replacement property. Not allowing the taxpayer to have any access to or constructive receipt of the transaction proceeds is one key element of the IRS statutes, which can allow the transaction to be deemed to be an “exchange” and allow deferral of capital gains and other taxes, instead of treating the transaction as a sale, which would typically result in capital gains being owed.  The QI’s involvement as an intermediary and segregating and escrowing the transaction proceeds is a critical element in having the transaction be considered a qualifying exchange as opposed to a sale by the taxpayer.   
2. Sell the Relinquished Property: The first step in a forward 1031 exchange is selling the property you currently own. The proceeds from this sale go to the QI and not directly to you to avoid constructive receipt, which would disqualify the exchange.
3. Identify Replacement Property: You must identify potential replacement properties within 45 days of selling the relinquished property. The IRS imposes restrictions on the number of properties that can be identified during this phase.  These restrictions come in the form of one of three rules based on the number of properties the taxpayer is attempting to list on their identification list.  The most popular option, the “Three Property Rule”,  allows the identification of up to three properties, regardless of their value. More properties may be identified under what is referred to as the “200% or 95 % Rules”, although these options are a bit more tricky and harder to navigate.  There is no obligation to purchase the identified properties, and they do not need to be under contract at the time they are Identified.  The IRS Is just looking for a list of properties that the taxpayer is interested in acquiring.  These properties can be swapped out anytime throughout the identification period.  After day 45, the taxpayer can only purchase properties that were submitted in the identification period.  
4. Purchase the Replacement Property: You must complete the purchase of the replacement property within 180 days of the sale of the relinquished property. The QI facilitates this transaction using the escrowed and segregated proceeds from the sale (along with any additional funds from new loans or outside cash, depending on the purchase price).

Like-Kind Property in Different 1031 Exchange Strategies

There are several different categories of 1031 exchanges, each catering to different investment strategies and circumstances. Does the definition of real property or like-kind property change for a given category? 

Forward Exchange: The most common type, where you sell the relinquished property first and then purchase the replacement property.  All exchanges structured here involve a forward exchange.  This is what will be reported to the IRS when filing.

Reverse Exchange:In a reverse exchange, the replacement property is acquired before the relinquished property is sold. To effectuate this, an independent LLC, called an Exchange Accommodation Titleholder (EAT), will be created, normally by the QI, to step in and acquire the replacement property on behalf of the investor. The primary goal here is to remove the property from the market and secure it for the taxpayer as the replacement property in their exchange. This satisfies the IRS requirement that the taxpayer must first relinquish ownership of their sale property before acquiring ownership in the replacement property.

While the definitions of like-kind and real property do not change in a reverse 1031 structure, there is an important point to highlight: many reverse 1031 exchanges conclude by assigning 100% of the membership interest in the EAT to the exchanging investor.  A simplified version of the process might look like the following.

1. A new LLC is created to act as EAT.
2. The EAT purchases the replacement property that the investor wants to end up with. 
3. The investor later sells their relinquished property.
4. The investor is assigned 100% of the membership interest in the LLC that owns the replacement property. This concludes the exchange. 

Earlier in this article, I mentioned that interests in a legal/business entity are not considered real property by the IRS.  However, in this case, the IRS holds that if you acquire 100% of the membership interest in a pass-through entity that owns real estate, such as a single-member LLC, then it will consider that to be identical to actually acquiring the underlying real estate itself.  This allows reverse exchanges to conclude by acquiring the EAT itself, which often means avoiding the delays and costs of setting up another closing. 

Construction/Improvement Exchange: In a construction/improvement exchange, an investor may often want to use the proceeds from the sale of the relinquished property to improve the replacement property. This strategy allows investors to acquire a property that might not meet their needs initially but can be developed or improved to suit their requirements.

The IRS stipulates that improvements made after the taxpayer takes ownership of the property do not count as like-kind property. Therefore, any improvements must be made before the taxpayer officially takes title to the replacement property.

Similar to reverse exchanges, the IRS allows an Exchange Accommodation Titleholder (EAT) to purchase and park a replacement property on behalf of the investor. The EAT holds title to the property during the construction phase and transfers it to the taxpayer to satisfy their exchange. This transfer must take place either when the improvements are completed or when the 180-day exchange deadline expires, whichever occurs first. 

Again, the technical definitions of real property and like-kind property don’t change in a construction/improvement exchange. However, not all potential improvements to a property count as real property for purposes of 1031 (see IRS Publication 544). In order for improvements to count as real property within the context of the exchange, they should be capital improvements that are permanently attached to the real estate, such as buildings or fixtures. Ineligible items include personal property such as furniture, most appliances, or items that typically fall under repair and maintenance, like painting or landscaping. 

Misconceptions About Like-Kind Property and Real Property

Despite their popularity, 1031 exchanges are often misunderstood. This is particularly true regarding what assets are eligible for 1031 treatment. Clearing up these misconceptions about like-kind property and real property can help investors make more informed decisions.

1. Misconception 1: Like-kind means identical property. Many believe that exchanging an office building requires acquiring another office building. This is incorrect. Like-kind refers to the nature of the property, not its specific use or quality. You could exchange an office building for raw land, a shopping center, or even a ranch, as long as both are real properties held for productive use in a trade or business or for investment.
   
2. Misconception 2: Any asset related to real estate qualifies for a 1031 exchange. While this may seem intuitive, it’s not entirely accurate. Items like mortgages, notes, bonds, stocks in a corporation that owns real estate, or shares in a real estate trust do not qualify as real property for 1031 purposes. Interestingly, there are some circumstances where long-term leases with a duration of more than 30 years can qualify as real property.
   
3. Foreign real property is considered like-kind to domestic (US) real property. This is, unfortunately, not true.  Even if you find a foreign asset that falls under the definition of real property, it cannot be exchanged for another real property asset located in the United States. This is because the IRS does not see foreign assets as like-kind to domestic assets.  However, it is possible to facilitate a foreign-to-foreign 1031 exchange (e.g. selling real property in Canada and reinvesting into real property in New Zealand). 

Conclusion

Whether you’re a seasoned investor or just starting out, the flexibility and tax advantages offered by 1031 exchanges make them a valuable tool in your investment toolkit. If you or your client want to maximize the strategies that 1031s can make available, it really helps to appreciate just how broad the definitions of real property and like-kind property are. Staying informed means making better investment decisions. 

Remember, every exchange is unique, and working with experienced professionals can help you navigate this complex process with confidence and ease.