Avoid Pitfalls in Section 1031 Exchanges by Defining Like-Kind Property

Section 1031 of the Internal Revenue Code provides real estate investors with a robust tax deferral strategy. It allows capital gains from the sale of a property to be deferred when the proceeds are reinvested in like-kind real estate.

However, to fully benefit from a Section 1031 exchange, it is crucial that both the relinquished and replacement properties meet the definition of like-kind. Failure to do so can result in the loss of these valuable tax advantages.

Defining like-kind property

The term "like-kind" refers to the nature or character of the property, not its grade or quality. Generally, most real estate held for investment or productive use in a trade or business qualifies — whether commercial, residential, or land.

However, several categories of property are excluded and can disqualify an exchange:

Inventory

Properties held primarily for resale, such as those developed or flipped for short-term profit, are considered inventory and do not qualify for a Section 1031 exchange. The distinction between investment property and inventory can be nuanced. Tax courts typically assess the original intent of the acquisition, how the property was held and managed, and the broader business activities of the taxpayer.

Personal property and Section 1245 property

Section 1031 does not apply to personal property, including machinery, equipment, and vehicles. While incidental personal property may be included in a real estate exchange, careful planning is required to understand the tax implications and to avoid disqualification of the tax-deferred transaction altogether.

Section 1245 generally covers non-Section 1031 eligible personal property assets, but it also includes certain real property, such as agricultural structures. Section 1245 real property may be treated as like-kind property for Section 1031 purposes so long as the replacement property includes Section 1245 real property value equal to or greater than the value of relinquished Section 1245 real property.

Other excluded or specialized property types

• Primary residences do not qualify, as they are not considered held for investment or business use.
• Vacation homes may qualify if they meet IRS safe harbor requirements for investment use. 
• Alternative property types, such as land leases, tenancy-in-common interests, and some water rights, may qualify but require careful structuring and professional guidance.

Consequences of a non-qualifying exchange

If a property fails to meet like-kind criteria, the transaction may be taxable rather than a tax-deferred exchange. To avoid unintended tax exposure, investors should:

• Conduct due diligence to verify the like-kind status of both properties
• Avoid property classified as inventory or personal use
• Confirm the property’s current and intended use aligns with investment or business purposes
• Work with experienced tax and legal advisors familiar with Section 1031 exchange rules

How CLA can help

While Section 1031 exchanges can provide significant tax advantages, they require careful execution. Missteps in identifying like-kind property or misclassifying assets can undermine the entire exchange. By understanding the requirements and planning carefully, real estate investors can successfully navigate the rules and enhance their tax deferral opportunities. CLA’s experienced advisors are ready to help you execute a successful Section 1031 exchange strategy.