A 1031 exchange is great for tax deferment, but not all properties qualify for this special tax treatment. In addition to the many rules to be aware of when considering a 1031 exchange, knowing if a property is even eligible is likely the first place to look.
Properties that Are Eligible for a 1031 Exchange
Properties eligible for a 1031 exchange are investment properties or those held for business purposes. What is considered an investment property? These are properties that the owner intends to hold for investment or property relinquished after being held for investment.
An income-producing real estate property would be considered an investment property. Additionally, the following are also eligible for a 1031 exchange:
- Vacant land
- Residential rental
- Commercial property
In the above wording, a property must be held for investment purposes. Held implies some amount of time, but how much? There's no black and white line regarding the amount of time an investment property must be held. It's mainly the intent of the property that is important (i.e., an investment vs. primary residence).
Which Properties Aren’t Eligible?
What about short-term development land or a property that an investor flipped? Neither of these properties qualifies for a 1031 exchange since they are considered inventory.
Also, the territory of land exchanged matters. A domestic-to-domestic exchange is fine. A foreign-to-foreign exchange is also fine. But a domestic-to-foreign exchange is not eligible.
A 1031 exchange cannot be executed for shares of a business such as a partnership, LLC, or corporation. However, a Delaware Statutory Trust (DST) does qualify for a 1031 exchange. It is the only form of indirect ownership that qualifies.
Primary Residence
Usually, the IRS does not allow a 1031 exchange with a primary residence. This is because the property isn’t being used as an investment property or being held for business purposes.
However, there are some exceptions to the rule. These can be found in section 121. A section 121 exchange provides a tax exclusion on the sale of a primary residence. A requirement of section 121 is that the homeowner has lived in the home for at least two of the last five years. The time in the home doesn’t have to be concurrent.
Section 121 allows up to $250,000 of gains to be excluded for a single filer or $500,000 if filing jointly. Section 121 can only be used once every two years. A 1031 exchange doesn’t have any use limitations.
Note that you can’t suddenly decide that you want to do a 1031 exchange on a primary residence because it's a rental property. Planning is generally required for the exchange to be successful.
You also can’t live in your house while claiming it as a rental property for 1031 exchange purposes. However, there are exceptions for a multi-family property.
When determining if a property is eligible for a 1031 exchange, it's best to go over it with someone familiar with the various 1031 exchange rules, such as a real estate tax specialist.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. Investing involves risk, including possible loss of principal. A bond's yield, share price, and total return change daily and are based on changes in interest rates, market conditions, economic and political news, and the quality and maturity of its investments. In general, bond prices fall when interest rates rise and vice versa. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Examples shown are hypothetical and for illustrative purposes only. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
