Are There Any Specific Rules for 1031 Exchanges on Commercial Properties?

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A 1031 Exchange allows you to swap two or more real estate assets while preserving your capital, making it appealing among many commercial property investors. For those who are about to undergo an exchange involving these types of assets, it’s normal to consider whether or not there are specific rules for these properties.

In this article, Realized 1031 shares the specific 1031 Exchange rules for commercial property and the situations where these apply. Keep reading to learn more about these applicable laws and processes.

Commercial Property 1031 Exchange Basic Requirements

All commercial properties follow the base rules set by the IRS for 1031 Exchanges. These include the following.

Like-Kind Property: Only like-kind assets can be exchanged. This is a broad definition, and the specific requirement is that these properties must have been held for business or investment use.

Timelines: The entirety of the exchange must happen within a 180-day period, which begins the day after the closing of the relinquished property’s sale. This also marks the start of the 45-day timeline, which requires you to identify three replacement properties.

Reinvestment of All Proceeds: You must reinvest all the proceeds from the sale of the relinquished asset into the replacement properties. Any non-like-kind property you receive will be considered a taxable boot. This includes leftover cash or mortgage relief.

No Direct Control of Funds: Exchangers must work with qualified intermediaries (QIs) to avoid taking direct control of the sales proceeds. Otherwise, this act would result in a taxable event.

Qualified Intermediaries: Aside from holding the proceeds in escrow, the QI is also the entity that oversees the entire exchange. Working with them is required for a compliant exchange.

Why IRS Guidelines for Commercial 1031 Exchanges Feel Like the Blueprint

At the most basic level, the rules we outlined above are the blueprint for most types of exchanges. That’s because this type of transaction was originally designed with large-scale business assets in mind. Big-box retail stores, office buildings, and healthcare facilities are a few examples.

Commercial buildings qualify as like-kind by default since they are unambiguously used for investment or income generation. This feature also means it’s easier for investors to match two properties for swapping.

Even so, there are a few specialized considerations and processes for some types of commercial property. Understanding these rules can help you determine if any apply to your exchange and maintain compliance.

Specialized Like-Kind Rules for Commercial Real Estate

Here are a few nuances that separate 1031 commercial property exchanges from other similar transactions.

Eligibility of TICs and DSTs

Tenancy-in-common (TIC) and Delaware Statutory Trusts (DSTs) are types of fractional ownership investments. While the ownership is in the form of interests, these are considered like-kind thanks to IRS rulings and procedures. As such, investors can exchange into properties with other investors, enjoying benefits like passive income and enhanced diversification.

Improvement Exchanges

An improvement or built-to-suit exchange allows you to use the proceeds not just to acquire the property but to sponsor its improvements. This also applies to land. The value of the construction must be completed and “built out” within the 180-day window to count toward your reinvestment requirement. This requires a specialized “Exchange Accommodation Titleholder” (EAT) to hold the title while the work is being done.

Depreciation Recapture

Section 1245 rules must be considered for those exchanging from commercial property to raw land. The accelerated depreciation may be recaptured in such a scenario since raw land doesn’t depreciate the same way as commercial property.

Mixed-Use Properties

When mixed-use properties are involved, only the real estate portion is allowed for the exchange. Any part of the property utilized for personal use will be taxed. This means that during the sale of the mixed-use relinquished property, the commercial part must be valued separately from the part for personal use. This practice also applies to the replacement property.

Wrapping Up: 1031 Exchange Compliance for Commercial Properties

In many ways, the rules surrounding commercial property 1031 Exchanges serve as the default for most other like-kind swaps. These include the 180-day timeline, what qualifies as like-kind, and the reinvestment rules. However, there are special scenarios where unique rules arise. Investing in DSTs, exchanging into raw land, or involving mixed-use properties for the swap are some of these circumstances. Having a clear understanding of these specific rules is key to ensuring compliance and increasing the chances of a successful exchange.