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Types of Properties that Benefit from a 1031 Exchange

April 25, 2024

The 1031 exchange is a strategy that helps investors defer capital gains taxes when they sell an investment property. To maximize the tax benefits of a 1031 exchange, you need to understand and fulfill the requirements to be sure that your transactions qualify. One of the key requirements is knowing the types of properties that qualify. Whether it’s a rental property or vacant land, understanding the eligible properties will prevent you from missing out on their tax benefits. 

At Universal Pacific 1031 Exchange, we’re committed to helping you maximize your 1031 exchange tax benefits and increase your investment return. Our experienced Qualified Intermediaries are always here to help you leverage the tax deferral benefits of a 1031 exchange and guide you throughout the process. Book a free consultation with us today to get started.

In this blog, you’ll learn the types of investment real estate and properties that can benefit from a 1031 exchange, properties that do not qualify, and possible challenges you may face while executing the exchange transactions.

Understanding the 1031 Exchange

Understanding the 1031 Exchange

A 1031 exchange, or like-kind exchange, is a provision established under Section 1031 of the Internal Revenue Code. The exchange allows property owners to defer capital gains taxes by selling a property and reinvesting the proceeds into a like-kind replacement property. Note that the exchange does not defer other taxes, such as property transfer taxes.

The primary benefit of the 1031 exchange is its ability to defer capital gains taxes when exchanging your relinquished property for a replacement property. Aside from deferring capital gains tax, the 1031 exchange grows your investment portfolio over time by making more capital available for purchasing more properties from your sale proceeds.

A 1031 exchange also allows you to diversify your portfolio to mitigate potential investment risks and losses due to tax on your real estate investments. For instance, you can sell a rental property and reinvest in a commercial property without triggering immediate taxes on capital gains. You can also take advantage of the 1031 exchanges to accumulate wealth by continually and strategically exchanging properties.

The IRS looks at certain criteria to determine your eligibility for a 1031 exchange. One of them is your intent to hold the property. Only properties held for productive use, such as trade, business, or investment purposes, qualify. Personal properties do not qualify. 

Additionally, the Internal Revenue Service (IRS) has strict timelines that guide the 1031 exchange. For example, you have only 45 days to identify replacement properties and 180 days to complete the exchange. Failure to meet these deadlines can jeopardize the exchange and attract immediate taxes on your profit. 

As part of the requirements, the IRS prohibits you from holding the exchange funds during the exchange process. As a result, you must ensure that you work with a qualified intermediary (QI). QIs hold this fund on your behalf in an escrow account. They also facilitate your exchange in compliance with IRS guidelines, making sure you qualify for its tax deferral benefits. 

What Type of Properties Benefit from a 1031 Exchange?

What Type of Properties Benefit from a 1031 Exchange?

As the name suggests, only like-kind properties can benefit from a 1031 exchange. This means they must be of the same nature and character but not necessarily identical. 

Generally, the IRS considers real estate to be of like-kind. This gives investors the flexibility to exchange different types of real estate property. For example, an investment property can be exchanged for commercial properties.

Also, the replacement property must be of equal or greater value to or greater in value than the relinquished property, even if you’re exchanging two or more properties for one replacement property. Furthermore, you must hold both properties for productive use for at least two years before and after the exchange.

Investment Properties

One of the key attributes the IRS checks in a 1031 exchange is your intent to hold the property, which must primarily be for investment purposes. This includes vacation rentals, residential buildings, condominiums, townhouses, new construction property, etc. For example, you can exchange your rental home for a shopping plaza using the 1031 exchange, as long as both properties are for investment purposes. 

Commercial Properties

A wide range of properties in commercial real estate qualify for a 1031 exchange. They include office buildings, warehouses, retail spaces, apartments, marinas, parking garages, shopping centers, hotels, motels, etc. With these diversified options, commercial property investors can be flexible and effective in managing their properties. This flexibility can help you adapt to changes in the real estate market while deferring commercial property capital gains taxes and boosting your cash flow.

Rental Properties

Generally, rental properties such as apartments, condo buildings, etc. are known for their potential to generate income through rental agreements or leases. This makes them more of an investment property; therefore, they are qualified for the 1031 like-kind exchange. 

Sometimes, you may want to convert your replacement rental property to a primary residence after the exchange. You can only do this after holding the new property for 5 years to maintain your tax deferral status even after the exchange.

Also, if your property is a vacation home, the IRS considers it a rental property if you meet certain requirements. For instance, you must have your property management rented out for at least 14 days each year. And you’re only allowed to personally use it for less than 14 days, or 10% of the overall rental days.

Land

Land is another real estate property that qualifies for a 1031 exchange. You can swap one piece of land for another and not pay capital gains taxes. It can either be a parcel of land for developments, ranches, vineyards, farmland, raw land having no structures or improvements, etc. For example, you can exchange a vacant lot for farmland through the 1031 exchange tax code.

1031 land exchanges allow you to buy land in various locations with a low market value and potential for future development. For instance, you can diversify your property holdings and boost your cash flow by leasing them out for rental income or developing them while deferring capital gains taxes. However, you must ensure to hold both the relinquished land and replacement land for trade, business, or investment purposes.

Properties That Do Not Qualify for a 1031 Exchange

Properties That Do Not Qualify for a 1031 Exchange

It’s important to note that not every piece of real estate can be exchanged under Section 1031. Only a few categories qualify. As mentioned earlier, one of its eligibility criteria is that you must hold both the relinquished property and the replacement property for productive use. This means that you must own both properties to grow capital, appreciate property value, or generate income through rentals or leases. 

A vacation home, primary residence, or any other properties you own for personal use do not qualify. Likewise, properties held primarily for resale do not qualify. However, a vacation home can qualify if you rent it out for a period of at least 14 days per year, according to the IRS. But that’s not all; your usage of the same vacation property or home will be limited as a property owner as well.

According to IRC Section 1031 of like-kind exchanges, properties such as stocks, bonds, notes, interest in a partnership, beneficial interest, or certificates of trust do not qualify for 1031 exchanges since they are not like-kind properties.

Furthermore, it’s easy to think that property acquired through 1031 exchanges is tax-free, but that’s not true. With a 1031 exchange, you only defer capital gains tax and do not cancel them out. These taxes are deferred until you sell the property without using a 1031 exchange.

Planning and Execution of a 1031 Exchange

Planning and Execution of a 1031 Exchange

When executing a 1031, you’ll likely encounter some challenges. As a result, you may want to consult with an experienced tax professional to guide you through the process. Meanwhile, there are some general steps to help you initiate and complete your exchange. First off, you need to select the like-kind property you want to sell and the one you want to buy. Ensure that both properties are like-kind and within the U.S..

Next, choose an exchange facilitator called a qualified intermediary. They hold the funds generated from selling your relinquished property until your exchange is complete. Ensure to carefully choose a reputable QI to avoid losing money if they go bankrupt. Try to compare the fees of various QIs and be sure they are reasonable.

After you sell your property, decide if you’ll be reinvesting all or part of the proceeds in buying a replacement property. If you use a portion, you can only defer taxes on that portion; the rest will be taxed. 

Next, identify a replacement property within 45 days from the day you sold your property. Also, you have 180 days from the day you made the sale to buy an identified replacement property. Not meeting these deadlines can affect your exchange. Lastly, notify the IRS about your transaction by filing IRS Form 8824.

Navigating Challenges of 1031 Exchange

1031 exchange offers many benefits, but certain challenges can reduce your chances of enjoying them. Make sure to always be aware of these problems to finalize your exchange without issues. 

One of the common challenges you may face is choosing like-kind properties within the 45-day identification period, especially when multiple properties are involved. Also, it can be difficult to meet the IRS’s strict timelines for identifying and buying replacement properties, especially when you’re uncertain about the real estate market conditions. Preferably, ensure to have backup replacement properties in mind before starting the exchange.

To avoid these pitfalls, it’s crucial to consult a qualified intermediary who can walk you through the difficulties of the exchange while complying with IRS rules. It’s also wise to begin identifying potential replacement properties very early. This gives you enough time to negotiate and perform all relevant tasks.

Furthermore, in the process of the exchange, keep detailed records of every transaction associated with the exchange. This includes receipts, correspondence, and contracts. Also, be sure to avoid using your sale funds to settle your personal expenses or to invest in non-like-kind properties. This can rob you of the opportunity to successfully defer taxes on capital gains.

Contact a Qualified Intermediary to start a 1031 Exchange

A 1031 exchange allows real estate investors to defer capital gains taxes by selling a property and reinvesting the proceeds in another like-kind property. However, not all properties are eligible for the exchange. To qualify, you must own and use your property for business, trade, or investment purposes.

It’s wise to take advantage of this tax loophole to fully maximize its benefits. Consult with a tax advisor and work with a qualified intermediary to avoid challenges and errors. A qualified intermediary guides you and helps you stay compliant with IRS rules throughout the 1031 exchange.

At Universal Pacific, our licensed Qualified Intermediary in Los Angeles can guide you to ensure that you obey all federal and state laws during your 1031 exchange. Take the first step today by scheduling a complimentary consultation call with us.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.