How does my property qualify for  a 1031  Exchange

The con­ver­sa­tion regard­ing a 1031 exchange cov­ers many top­ics of dis­cus­sion among real estate investors, finan­cial advi­sors, and CPAs. There may be a basic ques­tion of How Does my Prop­er­ty qual­i­fy for a 1031 exchange.

By Al DiNi­co­la, AIF®
Jan­u­ary 21, 2023
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC

Real estate agents and bro­kers may also pro­vide their opin­ions on the advan­tages of the 1031 exchange. There are tax advan­tages of the Inter­nal Rev­enue Ser­vice (IRS) 1031 tax deferred exchange sec­tion of the tax code. CPAs who are review­ing client port­fo­lios each tax year may be in a posi­tion to at lease ask the ques­tion to some investors regard­ing the poten­tial sell­ing of invest­ment prop­er­ties. Specif­i­cal­ly, investors who had held invest­ment prop­er­ty for a num­ber of years may have ful­ly depre­ci­at­ed the prop­er­ty which lim­its the amount of poten­tial tax deduc­tions or poten­tial tax write offs. Poten­tial­ly the sale of one prop­er­ty that is ful­ly depre­ci­at­ed with the acqui­si­tion of anoth­er prop­er­ty may increase the tax favored write offs for cer­tain investors. Under­stand­ing what type of prop­er­ty qual­i­fies for a 1031 exchange is the core of the edu­ca­tion­al process. Recent­ly the uti­liza­tion of a Delaware Statu­to­ry Trust (DST) has entered the con­ver­sa­tion as well. How­ev­er, we need to first under­stand what type of prop­er­ty qual­i­fies.

Like-Kind is that Exact­ly Alike?

The term “like kind” is bat­tered around and some investors may not ful­ly under­stand that term which is step one. For tax­pay­ers to be eli­gi­ble for a 1031 there are qual­i­fi­ca­tions and stip­u­la­tions that need to be fol­lowed. So, what is the like kind stip­u­la­tion. To defer the cap­i­tal gains that may be due on the sale of an invest­ment prop­er­ty the replace­ment prop­er­ty must be of like kind. The def­i­n­i­tion of like kind means both prop­er­ties (the relin­quished prop­er­ty and the replace­ment prop­er­ty to be reviewed lat­er) must be used for used for pro­duc­tive use in a trade or busi­ness or both prop­er­ties must be held for busi­ness. (26 U.S.C. § 1031(a)).

Many of the ques­tions come from investors who may be con­sid­er­ing or enter­ing into a 1031 tax deferred exchange for the first time. Pri­or to get­ting to the time peri­ods for iden­ti­fy­ing replace­ment prop­er­ties and clos­ing dates the first item to be con­cerned with is what are the qual­i­fy­ing prop­er­ties. In oth­er words, what types of prop­er­ties can qual­i­fy as a replace­ment prop­er­ty. Are there geo­graph­ic con­sid­er­a­tions, val­ue con­sid­er­a­tions or oth­er unknown items.

The IRS does have a def­i­n­i­tion for like kind prop­er­ty.

“Like-kind prop­er­ty is prop­er­ty of the same nature, char­ac­ter or class. Qual­i­ty or grade does not mat­ter. Most real estate will be like-kind to oth­er real estate. For exam­ple, real prop­er­ty that is improved with a res­i­den­tial rental house is like-kind to vacant land. Also, improve­ments that are con­veyed with­out land are not of like-kind to land.”

R & R- mean­ing Relin­quished and Replace­ment

Under­stand­ing Relin­quished prop­er­ty and Replace­ment prop­er­ties is manda­to­ry. The IRS def­i­n­i­tion at first con­tain a lot of words that could be con­fus­ing. The relin­quished prop­er­ty is the cur­rent prop­er­ty that the investor owns and con­sid­ers sell­ing. Upon sale and clos­ing of the prop­er­ty this becomes the relin­quished prop­er­ty. That is step one in the tax deferred exchange process. In most cas­es this would be clas­si­fied as a deferred exchange. If you are suc­cess­ful in locat­ing a prop­er­ty to acquire that prop­er­ty would be ref­er­enced as the replace­ment prop­er­ty. The replace­ment prop­er­ty would be pur­chased with the pro­ceeds from the sale of the relin­quished prop­er­ty. (Please refer to oth­er arti­cles on the use of a Qual­i­fied Inter­me­di­ary (QI) who holds the pro­ceeds for the relin­quished prop­er­ty sale).
The IRS does state a per­son­al prop­er­ty (pri­ma­ry res­i­dence for exam­ple) does not qual­i­fy as a like kind prop­er­ty. There may be excep­tions to sec­ond homes depend­ing on per­son­al usage, rental times, and oth­er sit­u­a­tions.

“Both the relin­quished and replace­ment prop­er­ties must be held for use in a trade or busi­ness or for invest­ment. Prop­er­ty used pri­mar­i­ly for per­son­al use, like a pri­ma­ry res­i­dence or a sec­ond home or vaca­tion home, does not qual­i­fy for like-kind exchange treat­ment.”

Loca­tion, Loca­tion

The prop­er­ty loca­tion is impor­tant. To qual­i­fy both the relin­quished prop­er­ty and the replace­ment prop­er­ty must be locat­ed in the US. You may also qual­i­fy is the relin­quished prop­er­ty and the replace­ment prop­er­ty are in the same juris­dic­tion out­side the US.

Since around 2003/2004 under cer­tain cir­cum­stances DSTs have been uti­lized as replace­ment prop­er­ties. There are spe­cial­ists who deal with DST for cash investors as well as 1031 tax deferred exchanges.
The words “like-kind” for many first-time exchang­ers can be some­what con­fus­ing. What we want to avoid is after you close on what you think is the replace­ment prop­er­ty you receive a tax bill from the IRS with a state­ment that your exchange did not qual­i­fy. In some cas­es, the investor sim­ply did not fol­low the guide­lines. Does like kind mean if you own an apart­ment build­ing you need to buy anoth­er apart­ment build­ing? If you own a retail or office, do you need to match a replace­ment prop­er­ty that is also a retail of office build­ing? Actu­al­ly, you do not need to match the same prop­er­ty or asset class.

Like-kind would encom­pass real estate for real estate.

Here are a few exam­ples of accept­able like-kind exchanges.
• A mul­ti­fam­i­ly apart­ment build­ing for an indus­tri­al ware­house
• Vacant farm­land for an office build­ing
• A rental lake cot­tage for a con­do in the city
• A self-stor­age facil­i­ty for oil & gas roy­al­ties (actu­al­ly rep­re­sents the own­er­ship of the sub­sur­face of a prop­er­ty).
• Any retail or com­mer­cial prop­er­ty for oth­er real estate
• Mit­i­ga­tion cred­its may be exchanged for rental prop­er­ty.

What are the Restric­tions for Like-Kind?

Exchanges may involve per­son­al prop­er­ty or real prop­er­ty. Per­son­al prop­er­ty refers to the asset’s nature and char­ac­ter. Exam­ples of per­son­al prop­er­ty that are exchanged include (but are not lim­it­ed to) air­craft, heavy equip­ment and busi­ness assets. It is chal­leng­ing to eas­i­ly state when per­son­al prop­er­ty is like kind to oth­er per­son­al prop­er­ty. For the pur­pose of this writ­ing, we will attempt to clar­i­fy Like-kind with ref­er­ence to real prop­er­ty. Per­son­al prop­er­ty can not be exchanged for real prop­er­ty.
Stay­ing clear of unqual­i­fied assets under IRC §1031

There are a vari­ety of prop­er­ty that do not qual­i­fy includ­ing secu­ri­ties, stocks, bonds, and notes. Over the past few years, a lot of real estate was des­ig­nat­ed as a prop­er­ty being flipped. These do not qual­i­fy if being offered by a devel­op­er or a flip­per (per­son doing the flip). A builder who pur­chased vacant land and divid­ed the land into indi­vid­ual build­ing lots and offered the lots for sale would not qual­i­fy for a 1031 exchange under IRC § 1031(a)(2). You can­not exchange for­eign prop­er­ty for prop­er­ty in the US and vice ver­sa.

Final thoughts and next steps

If you are unsure as to what may qual­i­fy, please con­sult a pro­fes­sion­al who deals with 1031 on an ongo­ing basis. We are hap­py to answer any ques­tions regard­ing the 1031 tax deferred process along with ques­tions as to how a DST may work to your ben­e­fit. Many investors who have uti­lized a 1031 exchange com­bined with the DST have expand­ed their options in many ways. The selec­tion of prop­er­ties has expand­ed both in prop­er­ty styles and asset class­es. There is geo­graph­i­cal diver­si­fi­ca­tion that extend beyond the investor’s imme­di­ate loca­tion. These ben­e­fits cou­pled with the 1031 exchange ben­e­fits pro­vide invest­ment alter­na­tives.

DSTs are not for all investors. The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.
Thank you.

NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC