Qualified Replacement Property: Similar or Like-kind?
Section 1033 of the Internal Revenue Code of 1954 provides for the nonrecognition of gain when property is compulsorily or involuntarily converted. Section 1033(a) requires that such conversions occur "as a result of destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof." If an involuntary conversion results in a gain, the gain need not be recognized if the proceeds are invested in similar property within a specified period.
Replacement property qualifies under this section if it is "similar or related in service or use to the property so converted." The IRS is quite restrictive in its interpretation of the similar use standard:
- Reinvestment must be made in "substantially similar" property;
- Reinvestment must be a substantial continuation of the prior commitment of capital and not a departure from it;
- Character of the investment should not be changed (although replacement property need not duplicate the converted property);
- Transaction should allow a taxpayer to return as closely as possible to his original position
§1033(g)(1) provides a more lenient test for condemned real property “held for productive use in trade or business or for investment,” considering property of a like-kind to be similar or related in service or use. Like-kind property has a broader definition than does similar property. §1031(a)-1(b) provides that properties are of like-kind or like class if they are of the same nature or character, even if they differ in grade or quality. The most common example is rental income real estate replaced with other rental income real estate. Use by the tenants is not required to be similar, and can differ.
Property that does not qualify as like-kind may still be eligible under the service or use test, which the IRS has divided into two tests. Revenue Ruling 64-237 presents the distinction between two classes of owners: the owner-user and the owner-investor.
A functional test applies to owner-users. Property is not considered similar or related in service or use unless the physical characteristics and end uses of the converted and replacement properties are closely similar. For example, owner-users of a manufacturing plant must reinvest in replacement property having the same end use - another manufacturing plant. A warehouse would not qualify.
Determination of similar service to the owner-investor is focused on the similarity in the relationship that both properties have to the owner. In applying this test, the nature of business risks associated with the property, the management and service demands of the owner, and relationship to the tenants must be considered. Owner-investors can benefit from eased replacement standards, as the replacement of investment property with property of like-kind is treated as similar.
Examples of Similar in Use Property
- Improved rental property replacing unimproved land subject to construction contract
- One building replacing two buildings used for the same purposes
- Replacement of destroyed facilities on leased land in one location by construction of similar facilities on leased land in another location
- Stock in public utility corporations replacing stock in condemned private utility
Examples of Property Not Similar in Use
- Improved real estate replacing unimproved real estate
- Reduction in leasehold or mortgage indebtedness replacing real property
- Interest in real estate investment trust replacing leased commercial building.
- Shopping center replacing underdeveloped land
- Partnership interests replacing partnership assets
Examples of Like-Kind Replacement Property
Most real estate is considered like-kind to other real estate. Improved real estate is like-kind to unimproved real estate as both are the same kind of property (real property).
- Investment realty replacing condemned business realty, or vice-versa
- Duplex for a retail property
- Single family rental for a multi-family apartment
- Commercial property replacing condemned agricultural land
- Conservation easement replacing timberland, farm land or ranch land, provided easement qualifies as an interest in real property under law
Examples of Property That is Not Like-Kind
- Constructed motel on land previously owned replacing condemned mobile home park
- Personally-used residence replacing leased residential property
- Interest-bearing bonds and a savings account replacing income producing real estate
- Fee simple interest replacing 15-year leasehold
- Partnership interests in oil and gas properties replacing condemned oil and gas wells