Section 1031 of the Internal Revenue Code is actually divided into two sections, one dealing with 1031 exchanges on real estate; and the other dealing with 1031 exchanges on personal property. I’ve written an extensive number of articles about the requirements of real estate exchanges because that’s what most people want to know about. But you should also have a basic awareness of the rules governing personal property.

by Author Gary Gorman Founding Partner, 1031 Exchange Experts, LLC

When the IRS talks about “personal property”, they’re talking about stuff that moves (planes, boats, trains, cars, etc.). If you can move it, the personal property rules apply. In the real estate industry we see a lot of mixed-use properties – properties that have both real estate and personal property components. For example, hotels, motels, restaurants, bars and Bed-and-Breakfasts are all mixed use properties since they consist of both real estate and personal property. In other words, you have two exchanges when you sell these types of properties.

...you should also have a basic awareness of the rules governing personal property...

The big difference between real estate exchanges and personal property exchanges involve the concept of “like-kind.” In a real estate exchange, you can sell a purple duplex and buy an office building, or an apartment building, or a warehouse, or even bare land. Both your Old Property and your New Property, in a real estate exchange, are like-kind if they are both held for investment, so the rules are very flexible.

The rules are much more complicated for personal property. In an exchange of personal property, to be like-kind, both the Old and New Properties have to be used within the same business. Every business within the United States is assigned an industry classification number by the government from the North American Industry Classification System, or “NAICS.” (The NAICS manual that lists all the different classification codes is the size of a large, city phone book) To meet the IRS definitions of like-kind for Section 1031, both the Old and New Properties have to fall within the same classification code.

Assume, for example, that Fred and Sue own a Bed-and-Breakfast that they wish to sell and replace with a motel. Can they do a 1031 exchange? The Old and New Properties both have real estate and personal property components; both properties have land and a building, and both properties have furnishings in the guest rooms that are essentially similar (bed, night stands, dresser, television, etc.). So at first blush you would think they could do this exchange, (you would be correct about the real estate), but what about the personal property?

The NAICS classification code assigned to a Bed-and-Breakfast is 721191, but the code assigned to a motel is 721110. Since the two classification codes pertaining to the personal property are different, Fred and Sue would not be able to do a 1031 exchange for the personal property part of the sale. But they could do an exchange for the portion attributed to the land and buildings. The personal property portion of the exchange will be disallowed, even though the guest room furnishings in both properties were exactly identical, because Fred and Sue did not replace their sale within the same NAICS code. In other words, if Fred and Sue wanted to have a successful exchange of their personal property they would have to buy another Bed-and-Breakfast.

One thing should be obvious by now but needs to be emphasized if you are a real estate agent or broker, and your client is selling a mixed-use property, you are in way over your head on a very complicated transaction. As soon as you have a signed listing agreement, I strongly recommend that you contact a good, national, 1031 intermediary (preferably one with a strong CPA staff) and set up a conference call between the intermediary and your clients CPA and attorney. You need to have your strategy well planned before you get an offer on the property. Otherwise your client could unnecessarily end up paying a lot of tax.