Can a 1031 Exchange Be Used for Rental Property?

A 1031 Exchange is a popular investment strategy that allows you to swap like-kind properties to defer taxes on capital gains. The IRS has strict rules regarding which types of properties are allowed, so it’s natural for investors like you to wonder whether or not the assets you own are applicable. Rental properties, in particular, are a common inquiry because of their ubiquity in investment portfolios. 

The short answer is yes, a rental property does qualify for a 1031 Exchange. This quick guide details the specifics of this eligibility and the special considerations you’ll want to keep in mind.

Refresher on 1031 Exchanges

Named after Section 1031 of the Revenue Code, the 1031 Exchange refers to the swap of like-kind properties. “Swap” is key here since the investors must avoid making a constructive receipt through an outright sale. Done correctly, a 1031 Exchange allows you to defer capital gains taxes until a taxable event occurs.

The IRS has many rules surrounding 1031 Exchanges to prevent abuse. These include the following. 

• 180-day Timeframe: The entire transaction must happen within 180 days, with the first 45 days dedicated to identifying properties. 

• Equal or Greater Value: You must reinvest all the proceeds from the sale of your relinquished property to receive full tax deferral benefits, so the replacement property should have the same or greater value. 

• Held for Investment or Business Use: The replacement and relinquished property must have been held under qualifying scenarios, such as investment or business use.

In this discussion, the last rule is the most applicable given the nature of rental properties.

Are Rental Properties Allowed in 1031 Exchanges?

In the majority of cases, rental properties are allowable in 1031 Exchanges. The main requirement is that these assets must meet the qualified use criteria. In other words, the property must have been held for productive use (generated income) through investment, business, or trade. Given the nature of rental properties, these types of real estate typically qualify for the like-kind exchange.

• Long-term Rentals: Traditional rental properties, such as single-family rental homes, apartment buildings, and commercial spaces, are generally eligible.

• Short-term Rentals: Airbnbs, vacation rentals, and other short-term rental properties can qualify, but there are certain requirements you must reach to make the property qualify. These include rules outlined by the Revenue Procedure 2008-16. 

• Mixed-Use Properties: Only the portion of the property used for renting can qualify for 1031 Exchanges. 

Special Considerations and Restrictions

Apart from the special rules regarding vacation homes and other short-term properties, there are considerations to keep in mind before entering a 1031 Exchange with your rental property.

Holding Periods

The IRS may scrutinize the transaction if you held the rental property for less than a year, even though it was still used for investment or business. We recommend holding off the sale for at least one to two years. 

Primary Residence Conversions

While you can convert a rental property (acquired through a 1031 Exchange) to a primary residence, there are certain requirements you must follow to maintain the tax-deferred status, especially if you plan to take advantage of the Section 121 Exclusion later.

Foreign Properties Are Excluded

A U.S. rental property cannot be exchanged for a foreign property. Both must be within the U.S.

Wrapping Up: 1031 Exchange Rental Property Rules

Rental properties are among the most common types of assets exchanged during a like-kind swap. While these properties are generally accepted, investors should still keep in mind certain considerations to increase their chances of a successful exchange and maximum tax deferral. For more details, please contact Realized 1031 today.

The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation. 

Cited Sources:

https://www.irs.gov/pub/irs-news/fs-08-18.pdf 

https://www.investopedia.com/terms/s/section1031.asp 

https://www.irs.gov/pub/irs-drop/rp-08-16.pdf 

https://smartasset.com/taxes/converting-rental-property-to-primary-residence