There are several elements that must be satisfied in order to qualify for the tax deferral that a 1031 offers. One requirement is the property being sold and the property being acquired must be “like-kind”. Despite the increased number of 1031 exchanges being done, this topic is still one of the most misunderstood aspects of exchanging. If the real estate meets the “qualified use” requirement, then generally it will be considered “like-kind” (though there are some unusual exceptions). You can sell land and buy a rental property, or sell a retail building and buy an apartment complex. Though most think of real estate when they hear 1031, until the TCJA tax law change became effective January 1, 2018, there were many other categories that were qualified property. The definition of what was like-kind for these other categories was very limiting and these type of assets, like business aircraft, could not be sold and a cement truck or retail center bought without violating the standing like-kind rules. Now the only qualified property is real estate. Thankfully, the definition of like-kind for real estate is very broad.
Real estate that meets the qualified use requirement (see below) is best defined by using the process of elimination. There are only three primary uses that do not qualify for 1031 purposes. If the real estate being sold or purchased is your primary residence, it is covered under §121, and is not eligible for exchange treatment. Secondly, a personal-use second home that is not rented will also not meet the 1031 standard. Finally, property that is held primarily for sale (inventory) is disqualified for 1031 purposes. Generally speaking, all other real property, besides these three categories, qualifies for the benefits of a 1031 and is considered like-kind.
Fortunately, even for these three disqualified categories, there are opportunities for a partial 1031 solution.
Selling a home with acreage– Homeowners are already entitled to a $250,000 or $500,000 gain exemption under §121. Even so, if there is additional land around the house, or if there is a working farm or other parts of the property are used for business, you may be able to do a 1031 on that portion of the property that is not immediately surrounding the primary residence. Under these circumstances, the guidelines for applying a 1031 and primary residence sale as part of the same transaction are quite liberal. For example, forty years ago, a couple bought a new home on twenty acres for $250,000. The land has become very valuable; they have received an offer for $100,000 an acre that includes the house. If they sold, the gain would be $1.75 million, of which only $500,000 would be exempted (under section 121 for the sale of the house). Taxes would be due on $1.25 million of the gain.
Using a 121/1031 strategy, this gain could be divided or allocated into two parts. Their home and two acres (what might be considered a normal lot size for the area) might be valued at $700,000; the investment land making up the remaining 18 acres could be valued at $1,300,000. The couple then could use the $500,000 gain exemption for the $700,000 primary residence portion of the sale and do a 1031 on the remaining $1.3M of land. Using this strategy most, if not all, the gain could be deferred.
Vacation Investment Property– Many times, the term “vacation home” is loosely used to describe either a personal use 2nd home or a vacation rental property. To fully be considered investment property for tax purposes, the owner cannot personally use the property more than 14 days out of the year or 10% of the time it is rented, whichever is greater. If the taxpayers limit their use and rent the property, the reporting will be on Schedule E of the tax return and should qualify for 1031 treatment. However, if the taxpayers use it more than the allowed time, then it will probably be considered a personal use second home that would be reported on Schedule A and would not qualify for any type of gain exemption. Usually, Schedule E property qualifies and Schedule A property does not.
The solution is to change how you use this second home a year or so prior to sale by primarily renting it out. Your change of use allows your CPA to change the reporting from Schedule A to Schedule E so that when you sell, you should be able to do a 1031. Revenue Procedure 2008-16 lays out the rules for rental and personal use when the property is part of a 1031.
Property Held Primarily For Sale (also called Inventory) – There is no minimum timeframe that an investor must own a property before it qualifies for a 1031 exchange. So, to understand if a property might be inventory, it is best to look at how the property is treated, primarily during the 24 months prior to the sale or after the acquisition. This applies to both the property being sold (relinquished) and the property being purchased (replacement).
For relinquished property – if any of the typical steps a developer might take occur 1 to 24 months prior to sale (such as subdividing the land into lots, putting in utilities or streets or building property that is immediately offered for sale) then the property will probably not qualify for an exchange. For replacement property – if immediately after the exchange the owner raises a for sale sign, or signs a listing agreement, fixes up and sells the property without renting it, or takes other action steps that show the owner’s intent to immediately sell, then the property does not meet the qualified use test which could invalidate the exchange.
There are potential solutions for most situations. Don’t fix up and sell, but rent out the property for a year before you sell. Sell the land after you get the zoning, but before any major improvements are done. For new construction of office condos, houses, or townhomes, you could apply a lease-purchase strategy that allows the tenant to buy after one year. Every situation is unique and there usually is a strategy that will allow for a 1031.
There can be legitimate reasons why a property that was just acquired might be sold that would not invalidate a 1031. For example, if the exchanger purchased a property, but could not get the desired zoning, a quick sale might be justified. Also, it might be acceptable if an exchanger received an amazing offer from an unsolicited buyer on the property just acquired. They should be able to sell and do another 1031 if it is absolutely clear the exchanger did not intend for an immediate sale. The death of a family member that may also cause a quicker, legitimate sale will also not harm the exchange just completed. These are all events that are out of the exchanger’s control, and would not invalidate an exchange.
To summarize, except the three qualified use exceptions mentioned above, all other investment real estate is like-kind with all other types of investment real estate. This broad definition allows a great deal of flexibility in using a 1031 to exchange into investment real estate that fits your current goals and objectives.
