When it comes to 1031 exchanges, many investors tend to focus on assets that have a singular use, no matter what sector. This could mean finishing the exchange into a multifamily home, a shopping strip, or a warehousing facility. However, mixed-use properties have their own rewards.
To successfully invest in a mixed-use asset through a 1031 exchange, a proactive investor should understand these opportunities and any challenges that may arise. Below, Realized 1031 shares how to successfully do a 1031 exchange into a mixed-use property to help you get started.
Understanding Mixed-Use Properties
As the name implies, mixed-use assets combine two or more components into a single structure. The most common configuration is residential and commercial portions, but there are others, like commercial and industrial or residential and institutional (e.g., university buildings with student housing).
For 1031 exchanges, mixed-use buildings with residential components add a layer of complication because of key like-kind exchange rules. The most applicable is that the asset must be held for investment or business use, which is also referred to as the qualified use requirement. If a portion of the mixed-use building is used for personal residence, then this leads to a question of whether the structure is qualified at all or not.
The 1031 Exchange Process: A Quick Recap
A traditional 1031 exchange, while complex, follows a standard process and various requirements. Both replacement and relinquished assets must have been held for productive use to qualify for tax-deferral status. Plus, a qualified intermediary is necessary to supervise the entire transaction and ensure an arm’s-length transaction. The entire exchange must happen within 180 days to maintain the tax-deferral advantages.
Mixed-use properties are not exempt from the qualified use requirement. So, what happens if one unit in the building is used as a personal residence? What if you plan to do that yourself?
1031 Exchange Mixed-Use Property: Key Considerations
The main issue you’ll encounter in the scenario we set up above is that you cannot completely qualify the entire mixed-use property for the 1031 exchange. Only the portion that’s used for investment or business purposes will be allowed in the swap. This limitation presents a few challenges you’ll need to keep in mind.
- Partial Tax-deferral: You cannot defer capital gains taxes for the equivalent value of the personal residential unit.
- Valuation and Allocation Challenges: You can still fully defer all capital gains taxes provided that the replacement property’s value minus the disqualified residential unit is still equal to or greater than the relinquished asset. However, you’ll need to determine the fair market value (FMV) of these two portions to divide the percentage accurately. The special appraisals will cost more than regular ones.
- Different Lease Structures: This issue has more to do with the nature of mixed-use properties and not strictly with regard to 1031 exchange requirements. Because you’re managing both commercial and residential tenants, you may be dealing with vastly different lease types, tenant rights, and management strategies. Commercial leases tend to be longer and more customizable, while residential leases are more regulated. This duality can complicate the management of the replacement property.
Wrapping Up: Exchanging Into Mixed-use Properties
Entering a mixed-use investment through a 1031 exchange is a promising move. However, there are a few considerations you need to keep in mind to increase the chances of a successful swap. Understanding the nuances of property use, valuation, and what qualifies for an exchange is critical to avoid costly missteps and take full advantage of this strategy.
Sources:
https://www.irs.gov/pub/irs-news/fs-08-18.pdf
https://sekoconstruction.com/2023/02/20/what-is-a-mixed-use-building/
