What Can Disqualify a Property from Being Used in a 1031 Exchange?

Section 1031 of the Internal Revenue Code allows taxpayers to use like-kind exchanges to indefinitely defer capital gains tax liability on the sale of real property that has appreciated in value. The definition of “like-kind” property is extremely broad—as the IRS explains, “[r]eal properties generally are of like-kind, regardless of whether they’re improved or unimproved.” Even so, there are limits on the types of property that can qualify for a 1031 exchange. Learn more from the 1031 exchange specialists at 1031 National Services:

Certain Types of Property Generally Don’t Qualify for a 1031 Exchange

Despite the breadth of Section 1031, not all types of property are eligible to be used in a 1031 exchange. In fact, there are a variety of factors that can disqualify a piece of property from like-kind exchange treatment. For example, the following types of property generally will not qualify for like-kind exchange treatment under Section 1031:

Primary Residences

Section 1031 only applies to property “held for productive use in a trade or business or for investment.” This means that it does not apply to primary residences. Even if you hope to sell your home for a profit in the future, this does not qualify as holding your home “for investment” under Section 1031. Keep in mind, however, that you may qualify for the home sale tax exclusion instead.

Second Homes and Vacation Homes

Since second homes and vacation homes are also not held “for investment,” they also do not qualify under Section 1031. Here, too, even though you may hope to sell your second home or vacation home for more than you paid, the “purpose” of owning the home—according to the IRS—is still your own personal enjoyment.

“Flip” Properties

Many real estate investors are surprised to learn that “flip” properties also generally do not qualify for like-kind exchange treatment under Section 1031. This is due to a provision in Section 1031, which states that the law “shall not apply to any exchange of real property held primarily for sale.”

With these exclusions in mind, what types of property can qualify for a 1031 exchange? Generally speaking, properties that may qualify for a 1031 exchange include:

• Business Premises – As noted above, property held “for productive use in a trade or business” expressly qualifies for like-kind exchange treatment under Section 1031. Thus, business premises will generally qualify.
• Rental Properties – Rental properties also generally qualify because they are held “for investment” and not “primarily for sale.” This applies to both multi-unit rental properties, such as apartment buildings, office buildings, and strip malls, as well as single-family rental properties.
• Other Real Estate Held for Investment – Other types of real estate, including vacant land, held for investment generally qualify for like-kind exchange treatment under Section 1031 as well. As noted above, a vacant parcel does not need to be exchanged with another vacant parcel to qualify for a like-kind exchange.

It is also important to note that real property that doesn’t currently qualify for a 1031 exchange may qualify if you make some changes. For example, if you rent your primary residence, second home, or vacation home before selling it, then you may be able to claim tax deferral under Section 1031.

Additional Factors that Can Preclude Like-Kind Exchange Treatment (Indefinite Tax Deferral) Under Section 1031

Importantly, even if two properties generally qualify for like-kind exchange treatment under Section 1031, there are still various factors that can render the proposed exchange ineligible for tax deferral. For example:

• Failure to Meet the Timing Requirements Under Section 1031 – Section 1031 exchanges are subject to strict timing requirements. Failure to meet these timing requirements, even by a day, can preclude like-kind exchange treatment.
• Failure to Use a Qualified Intermediary – In the vast majority of circumstances, complying with Section 1031’s requirements involves engaging a qualified intermediary to manage the funds involved in the exchange. Failure to use a qualified intermediary when required can also prevent property owners from claiming indefinite tax deferral.
• Exchanging U.S. and Foreign Real Estate – Under Section 1031, property in the U.S. is not considered of “like kind” with property held in a foreign country, no matter how similar the properties may be. While properties in two different foreign countries may qualify for like-kind exchange treatment, a property located in the U.S. cannot be exchanged with a property in any other country under Section 1031.

Contact the 1031 Exchange Specialists at 1031 National Services

If you have questions about whether a proposed exchange of real property qualifies for like-kind exchange treatment under Section 1031, we invite you to get in touch. Call us at 888-872-1031 or contact us online to speak with one of our 1031 exchange specialists for free.