What Can Derail a Property's Eligibility for a 1031 Exchange?
What Can Derail a Property's Eligibility for a 1031 Exchange?
The 1031 exchange encompasses several rigid requirements, which include the following:
- The relinquished property must be exchanged for replacement property/properties of equal or higher value.
- The exchanger/investor must strictly adhere to specific calendar deadlines.
- A Qualified Intermediary (QI) must assume control of all funds and proceeds throughout the exchange procedure.
Furthermore, one non-negotiable aspect of a 1031 exchange is the properties involved. It is important to note that while this process can be advantageous for deferring capital gains tax and depreciation capture expenses, not all properties qualify for a 1031 exchange.
In the Past,
Specific categories of personal or intangible properties such as machinery, equipment, collectibles, patents, and copyrights were considered eligible for 1031 exchanges. However, the enactment of the Tax Cuts and Jobs Act in 2017 brought about a significant change. This legislation rendered many previously eligible assets ineligible for like-kind exchanges. Presently, only "real property held for productive use or investment" meets the criteria for eligibility for a 1031 exchange.
Taking a Closer Look,
It is important to note that not all types of real estate are eligible for a like-kind exchange. As specified by the IRS, the following categories of real estate do not qualify for like-kind exchange treatment:
If you're considering purchasing and flipping a house, it's important to understand that such properties cannot be included in a 1031 exchange. The IRS categorizes this type of real estate ownership or transaction as "stock in trade" or "held primarily for sale." To determine if a property is held primarily for sale rather than for investment, several parameters are considered:
- The original purpose and intention behind purchasing the property at the time of sale.
- The extent of improvements made to the property.
- The frequency and continuity of sales made.
- Your primary occupation or business.
- Efforts made for advertising, promotion, or finding buyers.
- Listing the property with brokers.
- The duration of property ownership.
Essentially, if your intention was to buy a property, make improvements, and then sell it to another buyer (flipping), it does not qualify for a like-kind exchange. Additionally, selling an investment property within 12 months of its acquisition can raise concerns with the IRS.
When it comes to your primary residence, which is the place where you reside most of the time, it is not possible to exchange it through a 1031 exchange. Although your home may appreciate in value over time, it does not fall under the category of real estate held for trade or investment.
The only scenario in which a primary residence could potentially qualify for 1031 exchange treatment is if you decide to convert it into a rental property instead of using it as your own dwelling. However, even in this case, there are strict rules that must be followed.
First and foremost, you are not allowed to continue living in the property while it is being rented out. Secondly, in order for the property to be eligible for a 1031 exchange, you should plan to hold and rent out the house for a minimum of two years. These requirements must be fulfilled to meet the criteria for a like-kind exchange involving your primary residence.
When it comes to foreign real estate and 1031 exchanges, there are certain limitations and considerations to be aware of. You have the ability to relinquish a property within the United States and replace it with another property anywhere else within the United States. Additionally, it is possible to exchange U.S. real estate for properties located in the U.S. Virgin Islands and Guam, but not for properties in Puerto Rico.
However, it is important to note that you cannot exchange a U.S. property for one located in Canada, Mexico, or any other country outside of the United States. On the other hand, it is possible to exchange foreign real estate that is held for trade or investment for real property located in any country other than the United States.
Nevertheless, it's crucial to keep in mind that each country has its own specific rules and regulations regarding property purchase, sale, and exchanges. Therefore, thorough research and understanding of the applicable rules in each country involved are essential.
What to Know
Before proceeding with a 1031 exchange, it is crucial to have a clear understanding of the deadlines and regulations involved. Additionally, it is imperative to ensure that both the real estate you intend to exchange and the property you wish to acquire meet the qualifications set by the IRS. Neglecting to verify these qualifications beforehand can result in unforeseen tax liabilities.
To avoid potential complications and unexpected tax bills, it is essential to thoroughly research and consult with professionals who specialize in 1031 exchanges. By doing so, you can ensure compliance with the necessary requirements and make informed decisions throughout the exchange process. Taking the time to be well-informed and diligent in your approach will help safeguard against any unfavorable tax consequences.
General Disclosure
Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
- There’s no guarantee any strategy will be successful or achieve investment objectives;
- All real estate investments have the potential to lose value during the life of the investments;
- The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- All financed real estate investments have potential for foreclosure;
- These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits