What Qualifies as a 1031 Exchange?
As the nation’s most trusted 1031 Accommodator, our team of industry experts receive a lot of questions about the 1031 Exchange, especially since it’s been part of the Internal Revenue Code since 1921, and allows property owners to defer taxes when buying and selling commercial or investment real estate. Plus, the 1031 Exchange received a lot of news coverage from the Biden Administration, and is still misunderstood, even by members of Congress.
“Section 1031 exchanges are often misunderstood as another tax strategy used by the wealthy or corporate companies as way to avoid paying taxes. When in actuality the transaction is more commonly used by the average real estate investor,” said Justin Amos, National Sales Manager & Account Executive, 1031 Specialist at JTC Americas. “From job creation, capital relocation, and potential to revitalize communities, 1031 exchanges offer more to the U.S. than meets the eye. Education for all parties involved will be key to the continued success of the program.”
To help you better understand what truly qualifies as a 1031 Exchange, below is a compilation of our frequently asked questions about the general real estate rules, especially for vacation property homes and developing land.
Why are 1031 Exchanges only limited to real estate?
Starting in 2018, tax-deferred exchanges under Section 1031 was valid only for the buying and selling of real estate.
The change is set forth in Sec. 13303 of the tax reform bill, which contains the following language:
- Section 1031(a)(1) is amended by striking ‘‘property’’ each place it appears and inserting ‘‘real property’’.
The result of this modification is that 1031 exchange treatment for “personal property” exchanges — such as buying and selling of tangible depreciable property, including aircraft, automobiles, and heavy equipment; or of intangibles, like patents and mineral rights — which have long been eligible for Section 1031 exchanges, will no longer be allowed. But for a taxpayer who sold their relinquished property on or before December 31, 2017, an otherwise valid like-kind exchange will still qualify, even if the replacement property is acquired during 2018. Similarly, an in-progress parking arrangement/reverse exchange might also qualify if the replacement property was acquired on or before December 31, 2017. However, the legislative language refers to the taxpayer and not to the parking entity (the exchange accommodation titleholder) as the acquirer, which calls into question what exactly the drafters had in mind.
Admittedly, for the average exchanger, this change won’t make a difference: commercial and investment real estate already makes up the great majority of 1031 exchange property, and the existing rules for forward and reverse exchanges of real estate under Section 1031 remain unchanged.
Want to take the next step in having a successful 1031 exchange? Download our 1031 Exchange Solution sheet!
Can Buying and Selling of Multiple Properties Qualify for a 1031 Exchange?
A typical 1031 exchange involves the buying and selling of one like-kind business or investment property for another. However, selling one property and acquiring several replacement like-kind properties or selling several properties and buying one replacement property is also allowed, assuming the exchange follows designated guidelines. Additionally, an investment property can be exchanged for a business property, so long as both are like-kind.
Although IRC Section 1031 enables a property owner/exchanger to acquire multiple properties, it is important to remember that the identification rules apply differently to multiple property situations. An exchanger may identify up to three like-kind properties as replacement property per exchange, regardless of value, or any number of replacement properties as long as their aggregate value does not exceed 200% of the fair market value of the relinquished property(ies). An exchanger can also identify any number of replacement properties as long as they actually acquire at least 95% of the value of all the properties that were identified.
Either way, if an exchanger has multiple 1031 exchange properties they wish to undertake, they must apportion their original basis in the relinquished property(ies) amongst the replacement property(ies).
Using a Qualified Intermediary who is very experienced with handling all types of exchanges is the best way to increase likelihood for a successful exchange.
When Does Vacation Property Qualify for a 1031 Exchange?
Taxpayers buying and selling vacation homes may assume their property does not qualify for a 1031 exchange. However, in cases where vacation property has been primarily held for investment or business use, with occasional personal use, it may be possible to defer capital gains tax through a 1031 exchange. In order to defer capital gains tax through a 1031 exchange, both the relinquished and replacement properties must be held by the exchanger for productive use in a trade or business or for investment, not for personal use.
However, some properties, like vacation homes, may be used for both personal and business or investment purposes. For example, many taxpayers who own vacation property may rent the property to others for the majority of the year, but still occasionally use it for personal enjoyment themselves. To account for these situations, the IRS issued Revenue Procedure 2008-16, which provides a safe harbor allowing dwelling units to qualify for §1031 exchanges despite limited use for personal purposes.
To fulfill the safe harbor requirements and qualify for a 1031 exchange, the taxpayer must hold the relinquished or replacement vacation property for at least two years directly preceding or following the exchange. In each of the two 12-month periods preceding or following the exchange, the taxpayer must rent the property at fair market value for at least 14 days. However, the taxpayer may use the property for personal purposes for up to either 10% of the number of days the property was rented within the 12-month period or 14 days, whichever is greater.
Both the relinquished and replacement property being exchanged must meet the productive use or safe harbor requirements. Failure to comply with these requirements could jeopardize the outcome of the exchange and result in significant tax liability.
Does your rental property qualify for a 1031 exchange? Read our latest blog on 1031 Exchanges and rental properties!
Can I buy undeveloped land, develop it, then use it as relinquished property in a 1031 exchange?
Short answer: Typically, no — but with some careful planning, it may be possible.
Usually, real estate acquired to develop and then sell does not qualify under Section 1031. Why? Section 1031 only applies to investment property, which is held for investment and generally yields longer-term or market-based gains, or which is used in a trade or business. Therefore, if you buy land with the intent to develop it for sale, and then sell it, it won’t qualify.
However, if after developing the land it is held as investment property (or used in a trade or business) for some time, then the seller could potentially qualify. For example, if the seller were to lease the developed property for several years to demonstrate a business or investment purpose, then an exchange could be possible.
Ultimately, whether a property can be sold using a 1031 exchange depends upon what the seller intended to do with it when they bought the property. That intent can change over time as well. While the seller’s intent determines their ability to utilize a 1031 exchange, it’s also very important that the seller’s actions following their acquisition of the undeveloped land be consistent with their intent.
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