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.”
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 email@example.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.
NAMCOA® – Naples Asset Management Company®, LLC