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When making a tax deferred exchange under Section 1031 of the Internal Revenue Code, the law requires that the properties must be of “like kind”.
November 01, 2006 -- When making a tax deferred exchange under Section 1031 of the Internal Revenue Code, the law requires that the properties must be of “like kind”. This means the use of the property by the owner. The properties relinquished and acquired must be held by the owner as an investment or business property.
A business property can be any property used for income purposes such as rental property. This can be a house or any commercial rental property.
In some cases homeowners have converted a principal residence into a business property by moving from the home, then renting it. After a time, the house can be exchanged as a business property.
Less often, a home used as a rental might be converted into a principal residence.
Here is an example:
The owners, husband and wife, of a commercial building traded it for a luxury house. Their intent was to rent the house out and later sell it. At that time, houses were increasing in value more than commercial properties.
After two years, the tenant moved out so the owners decided it was a good time to sell the house. They consulted with their tax advisor on what tax would be incurred. The tax advisor advised them to hold off selling now. He further advised the owners to move into the home and convert it to their principal residence. After living there two years they could sell it and be eligible for the home owner‘s tax free $500,000 of their gain on the sale. They did so and made some of the gain from the previously owned commercial building into a tax-free profit.
Here are some examples of other exchange motivations:
• A geographical move. Exchange equity in income property to another part of the country.
• Eliminate active management of income property by exchanging to a low-management type of investment.
• Reduce current cash flow by acquiring a property that has large amortization instead.
• Expand business or commercial premises.
• Acquire more speculative property for a higher cash return. (Or, acquire a more conservative property for safety.)
• Increase leverage or decrease leverage.
• Divide a large property into several smaller ones for diversification. (Or, exchange several smaller properties for one large one for ease in management.)
An Exchange To Solve Two Problems
Tom Jackson had inherited a parcel of land that was zoned for commercial use. Jackson had the property for sale, because he wanted to use the money to purchase income property. He did not want to develop the land himself as he had no knowledge of the process.
Another owner, John Byers, was a developer who had built a group of small apartment buildings in a tract and was selling them. Quite a few of the separate buildings had been sold for cash, but several were still unsold after many months. Byers was anxious to sell and move on to another project.
Each owner's broker was aware of what the owners wished to do with the proceeds of the sale. Jackson’s broker was checking out all income properties since she knew that a tax-deferred exchange was probable for Jackson, if the right property was located. She contacted Byers’ broker and proposed that each owner should be shown the other's property for a possible exchange.
The owners liked what they saw. The exchange was completed. Jackson received the income property that he wanted in a tax-deferred transaction. Byers received land for his next building project. Byers’ end of the transaction was not tax-deferred, since a builder using inventory in either a sale or exchange will be taxable. |
