Which properties are Like-Kind? (You May Be Surprised!)
Like-kind real property is broadly defined: All real estate in the United States is like-kind. Section 1031 makes no distinction in qualities of real estate. A city lot is like-kind to farmland; an apartment building is like-kind to a shopping center, a condominium unit is like-kind to a factory, and so on.
Real estate located outside the United States (i.e. “Foreign” real estate) is not like-kind to real estate in the 50 states, even if it is located in an affiliated commonwealth or territory, such as Puerto Rico. The U.S. Virgin Islands (PLR 9038030) are an exception to the rule, as are Guam and the Northern Mariana Islands. (26 C.F.R. 1.935-1.)
Interests in a partnership are not like-kind, although the partnership itself can take advantage of a §1031 exchange. The exchange of partnership interests is specifically prohibited. §1031 (a)(2)(D). Individuals can only exchange their interests in the partnership property if they have made a valid election under §761(a).
Assets that may not appear to be like-kind often are. To determine the nature of a property interest, look to the law of the state where the property is located. Unfortunately, this may lead to conflicting results. For example, growing timber is not like kind to fee title in Oregon (Oregon Lumber Co. v. Comm., 20 T.C. 192 (1953); TAM 9525002), while it is like-kind to fee title in Georgia. Smalley v. Comm., 116 T.C. No. 29 (2001).
Trusts - Generally, certificates of trust or beneficial interests in trusts are specifically excluded from non-recognition treatment under §1031. However, the IRS will treat land trusts in Florida, California Hawaii, Indiana, North Dakota Virginia and Illinois as like-kind for the purpose of an exchange. The trustee is merely an agent to hold and transfer title, not a trustee who actively works to protect and conserve property for a beneficiary. Rev. Rul. 92-105, 1992-2 C.B. 204. Similar reasoning has been applied to allow the exchange of properties held in revocable trusts for estate planning purposes. Additionally, a beneficial interest in a Delaware statutory trust (DST) can be qualifying property in an exchange if it meets the requirements set forth in Rev. Rul. 2004-86. A beneficiary of a DST is treated as owning an undivided fractional interest in the DST’s real property for federal tax purposes, including §1031.
Leaseholds - A leasehold interest with an unexpired term of greater than 30 years (including optional renewal periods) is like-kind to a fee interest. A lessee can exchange his leasehold interest for a fee interest. However, the Lessor cannot exchange a lease for a fee interest, because the Lessor’ interest in the lease is only to receive money (rent), which is not like kind to the real estate. This "30-year rule" also applies to other terminable interests (e.g., a life estate or estate for years).
Development Rights - Development rights are a relatively modern land use planning tool that local governments grant to limit or prevent development in special zoning districts. These rights can be sold on the open market to owners of other real property in a receiving zone, permitting development of property in that zone beyond what would otherwise have been permitted. While development rights may not be treated identically to real property for all purposes, they are treated like real property in a number of important ways, including the fact that their grant is not discretionary, they appear to be permanent, are transferred in a manner similar to the transfer of a deed or an easement, and are recorded and indexed against the granting and receiving sites. Furthermore, the tax statutes and transfer tax provisions in most states usually define development rights as real estate. See: PLR 200901020.
The IRS has held that a fee interest in real property is like kind to development rights with respect to other property that the taxpayer already owned. PLR 200805012 (10-30-07). This ruling shows that the IRS is increasingly willing to rule on what property is of a like kind. For a number of years, this was thought to be too factual of an area for the IRS to rule on. Also, the IRS has once again held that an intangible right with respect to real property can be treated as real property under the exchange rules, provided the right is real property under state law. The IRS did not seem troubled by the fact that the development rights would be transferred to property the taxpayer already owned. (See Also: PLR 2006-49028, a stewardship easement is like kind to a fee interest.)
Even though a transaction meets the like-kind requirement, you must still meet all the other requirements of §1031 (i.e., holding; purpose) before a transaction can qualify for tax-deferred treatment. Contact your local First American Exchange office whenever you intend to dispose of real property used in your trade or business, or held for investment. We can help you harness the power of tax-deferral.
Water Rights / Mineral Rights: The IRS has also stated that perpetual water rights are like kind to a fee interest in real estate. The rights must not be limited in amount or duration. Additionally, shares in a mutual ditch, reservoir, or irrigation company can be exchanged if at the time of the exchange certain requirements are met including (1) the company is an organization described in I.R.C. § 501(c)(12)(A), and (2) the shares in such company have been recognized as constituting an interest in real property. Certain types of mineral rights that are considered real estate may also be exchanged. Owners need to examine the nature and duration of the rights granted and whether they are considered to be real estate in their state for tax purposes.