1031 Exchange Property
Section 1031 Exchange of the Internal Revenue Code permits a tax-deferred exchange of any real property in the United States against a like-kind property if the property is being utilized for investment. For example, a single-tenant property is eligible for a 1031 Exchange against a multi-tenant property.
IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or investment.”
1031 Exchange Property Guidelines
1031 Exchange guidelines provide tons of flexibility in structuring deals to broaden a real estate investment portfolio or otherwise satisfy strategic goals. For example, let’s suppose that an owner of the interest in an office building decides to trade that for a new like-kind property by taking the benefit of 1031 Exchange. Under 1031 exchange rules, you may exchange the building for a triple net leased investment in which one corporate tenant accepts all management responsibilities while you receive a monthly income. To be eligible for non-recognition of gains under an Internal Revenue Code Section 1031 exchange, commonly known as a like-kind exchange, both the properties, one that you let go (the relinquished property) and the property which is acquired (the replacement property) must be involved in productive purposes for a business, trade or investment. This is often addressed as a qualified purpose requirement.
As per the standard definition, a personal residence is not being used for business, trade or investment; therefore, it does not satisfy the qualified purpose requirement. However, a property which is partially being used as a residence and a part of it is being used for commercial purposes does qualify somewhat. Whether in the case of relinquished property or replacement property, none of them could be a personal residence to be eligible for a 1031 Exchange Also, owning a house only with the expectation that its value might go up does not classify as a smart investment.
The primary inquiry is one’s intention when a replacement property is acquired. If you genuinely aimed to treat it as 1031 Exchange property and not to occupy it as a primary residence, then you are on the right track.
How can intent be proven?
If you can’t satisfy the safe harbor analysis explained below, the conventional way is to indeed use the property for investment proposals for a notable period after the acquisition. If a house is rented for at least a year at fair market value, it is likely to indicate that the property was acquired for investment purposes. Many investors try to trick IRS by listing a property for rent at an amount which is significantly higher than market pricing or not at all listing the property. IRS is very familiar with such gimmicks, and they will see through that.
Here is a list to avoid common errors made with 1031 Exchange Property:
- Do not draw any plans for a principal residence or a vacation home immediately before or after a 1031 Exchange.
- Do not move into the house shortly after a 1031 exchange, even temporarily.
- Do not create a contract to acquire the replacement property contingent upon the sale of a primary residence.
- Always advertise and list to rent a property at a marketable rental amount.
- Make notations about the method used to establish the asking price of the rent.
- Never begin construction for personal use immediately after acquiring the property.
- Always sure that the replacement property is rent appropriate.
- Make notations about the details of all the potential tenants who visited the property with an intention to rent. They might be needed to be called upon as witnesses.
- If unforeseen circumstances led you to move into the house, make sure that is documented and keep relevant proofs handy. Examples – Losing job (Relieving letter), Illness (hospital records), Marriage (Certificate of marriage), Elderly parent, so on and so forth.
To be eligible for the Section 121 exclusion of gain, one must utilize their home as their primary residence for at least 2 of the last five years before its sale. Section 121 also has a special rule for 1031 exchange which dictates that the home needs to be owned for at least five years (either as 1031 exchange property or principal residence) before it is sold. Also, the amount of the exclusion one can demand will be prorated between the period it was utilized as a principal residence and the time that it wasn’t, and any depreciation involved will be taxable.
1031 Exchange enables your money to churn the maximum profit for you. However, the exchange process is extremely complex in nature and it would be wise to seek guidance from expert professionals. We have extensive experience in handling highly profitable exchanges for our varied client base.
For consultation and assistance regarding 1031 exchange call 888-993-2835 or email us at info@1031Xchange.com