The many in-stone requirements involved with the 1031 exchange include the following:
- The relinquished property must be exchanged into replacement property/properties of equal or greater value
- The exchanger/investor must adhere to specific calendar deadlines
- A Qualified Intermediary (QI) must take control of all funds and proceeds during the exchange process
Another non-negotiable factor involving a 1031 exchange? The properties involved. Specifically, while the 1031 exchange can be helpful when it comes to deferring capital gains tax and depreciation capture expenses, not all properties qualify for the process.
Once Upon a Time . . .
Not so long ago, certain types of personal or intangible properties could be used for 1031 exchanges. This included machinery, equipment, or collectibles. Patents and copyrights were also eligible for exchanges.
Then came the Tax Cuts and Jobs Act of 2017. This disqualified many assets that could previously be used in a like-kind exchange. These days, only “real property held for productive use or investment” is eligible for a 1031 exchange.
Narrowing it Down
Delving into this further, not all real estate is qualified for a like-kind exchange. According to the IRS, the following real estate doesn’t qualify for like-kind exchange treatment:
Real Estate Bought and Held Primarily for Sale
Are you thinking about buying and flipping a house? That’s great. What you can’t do with that house is relinquish it as part of a 1031 exchange. This is because the IRS considers this form of real estate ownership/transaction as “stock in trade” or “held primarily for sale.” So how can you determine if a property is held primarily for sale versus held for investment? Here are some of the parameters indicated:
- Why you initially bought the property and its purpose at the time of sale
- The extent of improvements you made to it
- The number of sales, and continuity of sales you make
- Your primary occupation or business
- Use of advertising, promotion, or other efforts to find buyers
- Listing the property with brokers
- Length of the hold
Basically, if your intent was to buy a property, improve it, then “flip” it to another buyer, it isn’t eligible for a like-kind exchange. Additionally, any investment property sold within 12 months of acquisition can also raise a red flag with the IRS.
Primary Residence
Can you exchange your primary residence – the place where you live most of the time? The short answer is “no.” While your home might increase in value, it’s not real estate you’re holding for trade or investment. The only possible way that a home could qualify for 1031 exchange treatment is if you decide to rent it, rather than live in it. But there are stringent rules here as well. First, you can’t live in the property while it’s a rental property. Second, you should plan to hold that house – and rent it out – for two years for it to qualify.
Foreign Real Estate
You can relinquish a property in the United States for a replacement property anywhere else in the United States. You can exchange U.S. real estate into real estate located in the U.S. Virgin Islands and Guam – but not into properties located in Puerto Rico.
But you can’t exchange that U.S. property for one in Canada. Or Mexico. Or anywhere else outside the U.S.
It is possible, however, to exchange foreign real estate held for trade or investment into real property in any other country – except the U.S. But keep in mind that each country has its own rules for purchase, sale, and exchanges.
Know Before Exchanging
If you decide to exchange your investment real estate into other like-kind real property, be sure to understand the deadlines and other regulations. Also be sure that the real estate you wish to exchange (and that you want to exchange into) is IRS-qualified. Failure to check before embarking on the exchange process could land you with an unexpected tax bill.
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. It should also not be construed as advice meeting the particular investment needs of any investor.
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.
There is no guarantee that the investment objectives of any program will be achieved.
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.
