What Qualifies for a 1031 Exchange?
By Jim Camp, CCIM, Associate Broker
This is the 2nd installment in a series of blogs on 1031 Exchanges.
Anytime one is considering conducting a 1031 Tax-Deferred Exchange it is good to know what does and does not qualify. There are a number of criteria that must be met in order to qualify.
What qualifies for a 1031 Exchange?
The first thing to consider is the “like-kind rule.” Both the relinquished and replacement properties must qualify as “like-kind.” The IRS specifies “like-kind” properties must have the same nature or character. The quality or grade of the properties does not matter. With this in mind, this rule allows the exchanger to utilize and consider many different types of properties as “like-kind.” One could exchange a duplex for an office building, or vacant land for a retail site, but everything must be located within the United States.
The Productive Use Rule: Typically, only those properties held for productive use in business or property held as investment will qualify for a 1031 Exchange. There are however some rule modifications allowing a property formerly held for personal use and now used in a productive manner to still be exchanged by the investor.
Property Values: The net market value of a replacement property in a 1031 Exchange must be equal to or greater than that of the relinquished property. This sum will include the total equity, debt, and profits from the sale plus any expenses such as commissions and/or fee to a Qualified Intermediary, real estate agents or brokers.
What does not qualify for a 1031 Exchange?
Properties that are not “like-kind.” An exchange of properties not considered to be “like-kind” will be disqualified by the IRS. Domestic and international properties may not be exchanged. Additionally intangible properties such as machinery, artwork, collectibles, and others do not qualify. Should the IRS disqualify the exchange, the investor could face a sizable tax burden based on the transaction.
Personal Use: Properties such as a primary residences or vacation homes do not meet the criteria of productive use, therefore, they do not qualify for a 1031 Exchange.
Property Values and Purpose: Remembering the requirement of the replacement property needing to be of equal or greater value, should the replacement property be of lesser value, the Investor would be required to pay capital gains on the boot. The term “boot” refers to cash the investor would receive when a gain is realized from the replacement property being of lesser value than the relinquished site.
Any investor should be aware that real property being held for sale also known as a dealer-property does not qualify for a 1031 exchange. This would equally apply to property being remodeled and sold- such as property being “flipped.”
Remembering these basic rules will help expedite the process for a new investor desiring to conduct a 1031 Exchange.
If you have any questions or have commercial real estate needs, please contact us!