In real estate, a 1031 exchange refers to swapping one investment property for another. The transactions allow investors to defer capital gains taxes that would otherwise be incurred. However, not all properties are eligible for this exchange. So, what qualifies for a 1031 exchange? This article explores the specifics of 1031 exchange property identification rules, including the different types of eligible properties, the requirements for eligibility, and what types of real estatedo not qualify.
1031 exchanges are challenging to accomplish because they feature strict rules and regulations that must be followed. Here are some of the guidelines for investors:
The property involved in the exchange should be held for either business or investment purposes. The incidental property rule suggests that properties owned primarily for resale, like inventory, do not qualify. This rule ensures that the 1031 exchange remains consistent with its objective of promoting active investment within the real estate sector.
In order to adhere to the 1031 exchange property identification rules, the identified properties need to be real estate property. This clarifies that items like vehicles, furniture, and other personal property are excluded from this provision. The aim is to uphold the fairness and integrity of the tax deferment process.
Another vital rule is that the relinquished property must be ‘like-kind’ to the replacement property. This ensures that the value of the real estate being exchanged remains unaltered after the transaction, providing equal benefit to every party involved. For example, properties identified for the exchange could be vastly different, such as a residential plot being exchanged for a commercial plot, thanks to this rule.
Identifying potential replacement properties for a 1031 exchange can be complex, largely because not all real estate types qualify under the Internal Revenue Code. However, several real estate categories meet the tax-deferred exchange criteria. Here are some of the top contenders:
The versatility of raw land makes it one of the most common choices for 1031 exchange transactions. The property identification rules stipulate that the land must be held for either business or investment purposes to be eligible. The advantage of raw land is the potential for strategic development or simply holding onto it for its appreciating value.
Residential rental properties can also qualify for a 1031 exchange, providing the landlord with opportunities for tax deferment. As the name implies, these are properties – typically single-family homes, apartments, duplexes, etc – that are rented out to residential tenants.
Business properties, or commercial real estate, can be part of a 1031 exchange. This category includes office buildings, retail complexes, warehouses, industrial units, and more. However, their status as ‘like-kind’ replacement properties depends on their use and function rather than their physical characteristics—meaning a retailer can exchange a shop for an office building and still meet the criteria for a 1031 exchange.
Properties under triple net leases also qualify for 1031 exchanges. In these agreements, tenants assume the cost of taxes, insurance, maintenance expenses, and lease payments. Property identification rules for triple-net lease properties stipulate that the same structure should be used in the replacement property to ensure it is a like-kind exchange.
Vacation rental properties, or short-term rentals, can also qualify for a 1031 exchange. However, it’s key to note that specific rules apply here. The property must be rented out for at least 14 days per annum, and personal use should be limited – in alignment with the rulings of the Starker case.
Partnering with a reputable qualified intermediary is the best approach for using qualified properties. Contact the 1031 Exchange Intermediaries to begin your exchange.
While various properties qualify for a 1031 exchange, not all real estate types are eligible. Here are some of the properties that do not meet the tax code requirements for these types of transactions:
Residential properties that the taxpayer uses as their primary dwelling or second home don’t qualify for 1031 exchange treatment. This rule aligns with the tax code’s primary intent of alleviating the tax burden on those properties used for productive business or investment purposes, not personal use.
As stipulated by the capital gains tax laws, properties intended for personal use — such as a family car or personal residence — are generally excluded from 1031 exchanges. These assets don’t meet the ‘held for productive use in a trade or business’ requirement in the IRS’ definition of like-kind property.
Though real estate held in a partnership can be exchanged, an individual’s interest in a partnership does not qualify for a 1031 exchange. Again, this is due to the Internal Revenue Service stipulating that this type of property does not meet the like-kind criteria.
Properties located outside the United States do not qualify for the 1031 exchange program. Following the American Exchange Company’s rulings, only real properties in the United States or its territories can be considered for a 1031 exchange. While this limits opportunities for international property investors, they may still benefit from understanding the property identification rules applicable to domestic exchanges.
Another property type overlooked for 1031 exchange qualification is stocks in real estate investment trusts (REITs). Although they relate to real estate transactions, they are considered personal property rather than real property — and are thus ineligible for a 1031 exchange.
Navigating the 1031 exchange property identification rules is challenging, and making a mistake can invalidate the process. The qualified intermediaries at 1031 Exchange Intermediaries have over 25 years of experience helping our clients defer the capital gains tax with comprehensive exchange solutions, including:
Contact us today to learn more about our solutions.