Not too familiar with 1031 Exchanges? Visit our 1031 Exchange Guide!
The 1031 Exchange program allows investors to defer capital gains and depreciation recapture on the sale of real property if they purchase a like-kind investment property within 180 days. As the nation’s most trusted 1031 accommodator, JTC Americas is equipped to answer the many questions you may have about the process.
In our 1031 Exchange Real Estate Guide, we discussed the basics of the program and how it’s possible for vacation homes and undeveloped land to qualify, but there’s another important type of real property that may be used in a 1031 exchange: rental property.
How does a 1031 exchange work for a rental property?
A key rule of 1031 is that the property must be held for business or investment purposes. Owning an investment property is a great way to earn passive income. Rental properties are the ideal candidate for a 1031 exchange based upon the definition of what qualifies as an acceptable relinquished property.
What kinds of rental properties are best for 1031 exchanges?
Let’s take a look at the different kinds of rental properties and what benefits they have.
Multifamily apartment buildings and commercial real estate:
If you own a multifamily apartment building or commercial real estate complex, you can be reasonably confident you qualify for 1031. These properties can be expensive to purchase and maintain, but there are options that make owning them easier.
It is possible for investors to pool their money to purchase a single property. One important rule of 1031 exchanges is that the title on the replacement property must have the same name as that on the relinquished property. That means if you buy into a property with several other people, they all have to be involved in purchasing the replacement property or else it won’t qualify.
Some investors participate in DSTs, or Delaware Statutory Trusts, that pool the funds of many investors to purchase a suite of properties, and each individual investor can do an exchange with their portion upon sale. The downside is that you can’t choose to sell when you want, but the benefit is that it’s managed by someone else.
It’s also possible to perform a 1031 exchange into a triple net lease (NNN) property that has lower maintenance and longer tenant leases, eliminating a lot of the work of managing rental properties and providing less risk.
There are a lot of options, and just because you can’t afford a large rental property on your own doesn’t mean you won’t be able to perform a 1031 exchange.
Duplexes and single-family residences:
Small rental properties have advantages over larger ones purchased with other investors. If only your name is on the title, you don’t have to worry about what your partners will do. Mortgaged property is fine under 1031, but the difference in the amount of the original property’s mortgage and that of the replacement property could result in a boot that would be taxed.
It’s also possible to live on the property and still qualify. If you own a duplex, you can live in one unit while renting the other out. This may give you flexibility to use either 1031 or section 121, which covers primary residences.
Your rental property does not have to have a tenant year-round in order to qualify. Short-term vacation rentals can be empty for part of the year without running afoul of the rules. This is useful for those who own a vacation home they wish use themselves part of the time and rent out the rest of the year.
The minimum number of days the property must be rented per year is 14. That’s not a lot, but you’ll also only be able to use it for 14 days yourself. If you’d like to employ the property for personal use more than that, you’ll need to rent it out longer so your use doesn’t exceed 10% of the days rented.
Can I do a 1031 exchange and then use the new property as my primary residence?
Let’s say you perform an exchange on your rental property and purchase a like-kind home that you plan to retire to after selling your primary residence. You can do so, but not immediately. And if you wish to eventually sell this new home under section 121, you’ll have to wait five years before it can be sold as your primary residence.
Should I sell my rental property in a 1031 exchange?
You may have reasons for selling that are specific to your property: it could be too much work to maintain, in an area where you no longer wish to live, or simply not growing in value in the way you’d like. In those cases, it’s important to know how 1031 can be used for your benefit.
If you haven’t held the property very long, you might not qualify for the long-term capital gains rate. Performing a 1031 exchange will ensure you can defer those taxes to a later date when you will qualify.
The biggest reason to sell now may be tax-related. As the Biden Administration moves forward with its tax plan, the rules regarding 1031 exchanges, capital gains rates, and the step-up basis are likely to change. You may want to take advantage of this benefit now in case it isn’t there in the future.
How do I perform a 1031 exchange with a rental property?
Rental properties can be a great source of passive income, but if you’re thinking of parting with yours, a 1031 exchange can help you save. Depending on your future plans, you’ll need to take specific steps to make sure you qualify and don’t leave money on the table.
The most important thing you’ll need is a qualified intermediary. JTC Americas has more than 30 years’ experience and has participated in tens of thousands of transactions, so we can help you make sure you’re doing everything right.
Thinking about doing a 1031 Exchange? Learn more about real estate and Section 1031 by visiting our 1031 Exchange Real Estate Guide!