Conducting a 1031 exchange is a tax-advantaged practice that allows you to delay capital gains tax payments. With the strict rules set by the IRS, however, it’s not surprising that many investors need clarification, especially if their asset has a few special characteristics. For example, can you do a 1031 exchange with distressed properties? The answer is yes, but there are a few considerations that make this yes more complicated than it seems.
Below, Realized 1031 has shared an informative guide diving deeper into this question. Let’s take a closer look.
What Qualifies as a 1013 Exchange Distressed Property?
Distressed properties refer to real estate assets that are under foreclosure or have extensive physical damage. However, this category is broad and also often used to refer to assets that are under either physical or financial duress, or both.
- Foreclosed or Pre-foreclosure Properties: A property that has already finished the foreclosure process is still considered a distressed asset.
- Properties in Physical Disrepair: We also consider properties requiring substantial renovation to fall under this category.
- Owners Under Financial Duress: Assets owned by motivated or financially distressed sellers can also be considered under this classification.
Conditions That Allow for an Exchange
A 1031 exchange is allowed for distressed properties, but you’ll still need to meet IRS requirements as outlined in Section 1031 of the Revenue Code.
Held for Investment or Business Use
A core requirement in the 1031 exchange is that both relinquished and replacement assets must have been held for investment or business purposes. As such, you can’t flip the distressed property quickly and have it qualified as a relinquished property. You must still hold it for rental income, appreciation, or business use before the asset can be exchanged. In other words, the property’s distressed state won’t matter as much. It’s the purpose of the investment that the IRS looks at more closely.
Like-kind Requirement
The IRS allows a broad interpretation of “like-kind” for real estate, which includes nearly all real estate held for investment. For example, you are allowed to exchange a dilapidated apartment building for a stabilized retail strip center, or vice versa. What matters is the nature or character of the property, not its condition or value.
Deadlines Must Be Followed
1031 exchanges must happen within 180 days, with the first 45 days being dedicated to identifying replacement properties. Failure to meet these deadlines will result in the loss of your tax-deferred status.
Unique Characteristics of Distressed Real Estate
While distressed properties are allowed in 1031 exchanges, these have added complications that make the transaction more challenging than a traditional sale.
- Title issues because of existing liens on foreclosed or pre-foreclosed properties make sales harder
- Repairs or renovations needed may complicate exchange timelines
- Lenders may be reluctant to provide financing solutions when you plan to acquire heavily damaged or legally encumbered real estate assets
- Bank-owned or auction properties may have strict closing schedules that don’t line up well with 1031 timing rules
Given these challenges, it’s essential to work closely with your qualified intermediary and other experts to navigate the transaction with confidence.
Wrapping Up: Like-kind Exchange Distressed Property
You are allowed to exchange distressed properties in a like-kind swap. As long as the assets follow IRS rules for eligibility, then you can relinquish or acquire them. The complication arises from the various problems of a distressed asset, such as title issues and extensive repairs necessary. As such, if you plan to use such properties for an exchange, there’s extra effort required to ensure that the exchange fully complies with IRS regulations and that potential tax liabilities are properly managed.
Sources:
https://www.investopedia.com/terms/l/like-kind_exchange.asp
