1031 Exchange Rules: What’s Not Allowed?

By Edward E. Fernandez | July 1, 2024

For seasoned real estate investors, the 1031 exchange is not just a transaction. It’s a strategy that enhances the value and diversification of their real estate portfolio. But it doesn’t come without risks.

Clarity on the rules and regulations shaping the landscape of 1031 exchanges is essential to ensure you know how to navigate this process confidently. 

In this article, we’ll explain the intricacies of what is and is not permitted in a 1031 exchange, shedding light on the boundaries that govern this powerful financial tool. Read on as we unravel the complexities and empower you to make informed decisions about 1031 exchanges.

 

The Purpose of 1031 Exchanges

A 1031 exchange is derived from Section 1031 of the U.S. Internal Revenue Code (IRC). It is a tax-deferment strategy that can defer capital gains taxes arising from an investment property’s sale.

This deferral opportunity emerges when you reinvest the proceeds from selling a property into another like-kind property.

The term ‘like-kind’ refers to real estate or other assets that share similar characteristics or nature. It’s crucial to reinvest in a property that aligns with these criteria to qualify for the tax deferral benefit. 

For instance, some investors believe if you sell a commercial building, you’d typically be required to reinvest the proceeds into another commercial property to meet the like-kind requirement. This is false; you can exchange properties of different types, such as selling an apartment and buying an industrial building, as long as they’re used for business or investment.

This tax-deferred exchange has proven to be an attractive strategy for real estate investors who want to make continuous investments without the immediate tax burden. You can roll over your capital gains from one investment to another to grow your portfolio.

How Investors Leverage 1031 Exchanges

1031 exchanges offer a potential avenue for investors seeking to optimize their portfolios and potentially maintain tax efficiency. However, it’s essential to consult with financial and tax advisors to determine if this strategy aligns with your investment goals and financial situation.

A 1031 exchange can allow investors to defer capital gains taxes and potentially increase their cash flow through rental income or other revenue streams generated by the new investment property. By deferring taxes, investors can allocate more funds towards acquiring a higher-value replacement property, which may result in higher potential income.

While selling a smaller commercial property to acquire a larger one can enhance cash flow and potential appreciation, the primary advantage lies in the ability to defer capital gains taxes through a like-kind exchange. 

This allows investors to reinvest the proceeds from the sale into a larger property that better aligns with their investment objectives. By leveraging the appreciation potential and increased rental income of the larger property, investors can maximize returns while deferring tax liabilities over time.

It’s important to note that investors have the flexibility to exchange their relinquished property for a replacement property that is of equal or greater value. This means that investors cannot downgrade to a property of lesser value and still qualify for the tax-deferral benefits of the exchange. Instead, they must reinvest the proceeds from the sale into a property that is of equal or greater value to maintain the tax-deferred status. 

Adhering to Specific IRS Rules and Timelines

The government created 1031 exchanges to encourage investment and economic growth. As mentioned above, the IRS has implemented guidelines to prevent abuse of 1031 exchanges. These aforementioned guidelines include: 

  • The IRS mandates that properties involved must be “like-kind,” indicating similar character or nature, regardless of grade or quality. This requirement offers flexibility, with most real estate investment properties qualifying as like-kind to others.

The criteria for a like-kind exchange are permissive. For instance, you can swap a rental home for a retail building, an apartment complex for an industrial property, or raw land for a senior care center.

  • The property should be held for investment purposes or utilized as a trade or business property. Personal properties and residences do not qualify.

  • To qualify, the properties must be for productive use—either investment or business. Some properties, like vacation homes, are also eligible, but you must consider nuances.

  • Investors are allotted 45 days from selling the original property to identify potential replacement properties. They then have 180 days to purchase the new property or properties.

  • Investors must hire a third-party Qualified Intermediary (QI) to facilitate the exchange. At no point in the process can investors hold any sale proceeds and conduct the reinvestment.

Navigating a 1031 exchange requires adherence to specific identification rules in addition to IRS regulations. These rules govern the properties investors can designate as potential replacements, ensuring compliance and facilitating successful exchanges: 

  • Under the Three Property Rule, investors can designate up to three properties as potential replacements without considering their total value.

  • Investors can identify more than three properties under the 200% rule as long as their combined value doesn’t exceed 200% of the market value of the relinquished property.

  • If the total value of identified properties exceeds 200%, investors must acquire 95% of their combined market value and utilize the 95% identification rule.

It’s important to note that investors can only choose one of these rules when undergoing a 1031 exchange. 

 

What Is Not Allowed in a 1031 Exchange? 

The IRS has set clear boundaries on what qualifies for this tax-deferral strategy. It ensures the exchange is used as intended: for investment and business, not as a tax shelter for personal assets.

The crux of the matter lies in how the IRS defines investment and business-use properties. According to tax regulations, both the relinquished and replacement properties must serve investment purposes or be used in a trade or business. Failure to meet this requirement renders the taxpayer ineligible to defer capital gains taxes through a 1031 exchange.

Examples of Prohibited Properties

Here are examples of properties ineligible for a 1031 exchange:

  • Primary residences: A 1031 exchange is specifically intended for investment or business properties. Personal properties are not eligible.

  • Vacation homes: Vacation homes generally do not qualify if used for personal reasons. For instance, a beach house where you spend every summer with the family is not eligible as it’s not held for investment purposes. Exceptions apply if a property meets specific criteria, i.e., vacation rental property.

  • Second residences: A weekend getaway spot is off-limits, even if it’s a potential retirement home. If these personal residences are not generating rental income or are used in a trade or business, the IRS will consider them for personal use.

  • Properties purchased for resale (flipping): If you’re flipping houses or holding land with the intent to sell it rather than rent it out or use it in a business, it’s a no-go. Real estate bought to renovate and sell quickly for profit is considered inventory. It is a property type not recognized as an investment by the IRS. Buying a fixer-upper, renovating, and selling it in a few months would not qualify for a 1031 exchange.

Tax Consequences

Attempting to include ineligible properties in a 1031 exchange can result in adverse tax implications:

  • Capital gains taxes: If the exchange fails, you’ll be subject to capital gains taxes upon the sale of the relinquished property. These can be substantial depending on your tax bracket and how long you’ve held the property.

  • Depreciation recapture: If you’ve claimed depreciation deductions on the relinquished property, you may also be required to pay depreciation recapture taxes upon its sale. This recaptures the tax benefits previously claimed and can add to your tax liability.

  • ACA taxes: Additionally, if your income exceeds certain thresholds, you may be subject to additional taxes under the Affordable Care Act (ACA). These taxes, such as the Net Investment Income Tax (NIIT) and the Additional Medicare Tax, can further increase your tax burden.

  • Disqualification of the exchange: If the IRS finds a non-qualifying property was involved, your entire exchange could be disqualified. Consequently, the anticipated tax deferral ceases to apply, and capital gains taxes become immediately payable.

  • Interest and penalties: In addition to the taxes owed, the IRS might also charge interest on the overdue taxes from the original due date. Penalties for inaccurate reporting or failure to pay the correct tax amount might also apply.

1031 exchanges come with strict guidelines and limitations. Understanding these rules and consulting with experts can ensure compliance.

 

What Are Eligible Property Types?

1031 exchanges encompass various real estate properties and certain business assets. Here’s a rundown of a few eligible property types:

  • Commercial real estate: Assets used for business or trade qualify for 1031 exchanges.
    • Office buildings
    • Retail spaces
    • Warehouses
    • Other properties used for business purposes qualify for 1031 exchanges.

  • Rental properties: Residential properties rented out to tenants are popular among investors due to income potential and appreciation.
    • Single-family homes
    • Apartment buildings
    • Duplexes
    • Multi-family rentals
    • Senior housing

  • Vacant land: Raw land not currently used for any specific purpose qualifies. Investors use 1031 exchanges to move capital from undeveloped land into lucrative investments.

  • Delaware Statutory Trust (DST): A DST, established as a trust under Delaware statutory law, offers a highly adaptable entity design and operation framework. In a DST 1031 exchange, the trustee assumes legal title and management duties, while investors act as beneficiaries holding equitable title.

What unites these properties is their utilization in investment or business endeavors. Allowing investors to defer taxes on the gain from sold assets gives them more capital for reinvestment. This is the intent behind 1031 exchanges: stimulate economic activity by encouraging the reinvestment of capital gains.

 

Maximize Tax Benefits through 1031 Exchanges

One of the primary ways investors can maximize the tax benefits of a 1031 exchange is through the use of DSTs as their replacement property. Savvy investors consider leveraging DSTs in their exchange for the following reasons: Tax benefits from 1031 exchanges can be beneficial for older investors. Here’s why:

Portfolio Diversification

For older investors, using a DST for a 1031 exchange presents an opportunity to broaden their investment portfolios without immediate tax obligations.

Consider an investor exchanging a long-held piece of vacant land for fractional ownership in commercial properties or a portfolio of properties leased to various tenants. This diversification strategy can mitigate risk and provide a more consistent income stream.

In the event that one investment within the DST portfolio underperforms or faces challenges, the diversified nature of the portfolio means that other investments may continue to perform well, thereby reducing overall portfolio risk. For instance, if one property experiences a downturn, income from other properties within the DST portfolio can potentially help offset losses, providing a more stable income stream for older investors.

Tax Deferral

One of the primary benefits of DST 1031 investments is the ability to defer capital gains taxes on the sale of appreciated properties. For older investors who may be looking to exit highly appreciated assets while minimizing tax consequences, a 1031 exchange into a DST can provide a tax-efficient solution.

Transitioning to Passive Income

For older investors seeking to reduce active management roles, DST 1031 investments offer an attractive solution.

With DST 1031 exchanges, investors can exchange actively managed properties for those with a more passive nature. For example, DST 1031 properties can include triple-net leases, where tenants are responsible for most expenses, providing ongoing income with minimal day-to-day involvement for the investor. 

This allows older investors to enjoy the benefits of real estate ownership without the burden of active management.

Estate Planning

With DST 1031 investments, property owners can perpetually engage in the cycle of exchanging real estate, deferring taxes until the properties are sold or until the investor passes away.

For older investors, this means they can pass on their DST 1031 investments to their heirs, leaving them with assets rather than liabilities. 

Upon the investor’s passing, heirs receive a step-up in cost basis equivalent to the fair market value of the DST 1031 investment. Inheriting the DST 1031 investment does not entail assuming depreciation recapture or capital gains tax liabilities, providing a tax-efficient way to transfer wealth to the next generation.

Streamlined Management

With DST investments, the property is professionally managed by a sponsor or asset manager, relieving investors of the burden of day-to-day management responsibilities. 

This hands-off approach can be particularly appealing to older investors who prefer a more passive investment strategy.

While there are notable benefits to DSTs, it’s important to consider the risks. These investments are generally illiquid and restricted to accredited investors. Risks also include sponsor creditworthiness and operator competency. 

As a DST beneficiary, the investor has no decision-making power in the asset. Therefore, performing your due diligence is crucial before making any investment decisions.

 

Tax-Saving Opportunities with 1031 Crowdfunding

1031 exchanges can present an opportunity for older investors to optimize their investment portfolios, reduce management burdens, and prepare for future estate transitions while deferring immediate capital gains taxes.

The complexity of IRS regulations makes 1031 exchanges less straightforward. Personalized guidance tailored to individual financial circumstances and investment objectives is crucial for optimizing tax advantages while upholding compliance.

Working with a team of experts, such as CPAs, realtors, and qualified intermediaries (QI), can help you navigate the complexities of tax law and real estate investment.

1031 Crowdfunding helps you explore investment opportunities and navigate the nuances around restrictions and regulations.

Discover a diverse array of investment properties tailored for maximizing tax deferral benefits with 1031 Crowdfunding.

Learn how 1031 Crowdfunding can support your next strategic investment endeavor.

 

 

 


This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees, and other expenses. This literature must be accompanied by and read in conjunction with a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. 

As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results, forward-looking statements and projections are not guaranteed to achieve the results described, and your actual returns may vary significantly. 

Investments in private placements are illiquid in nature, and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice, and you should consult with your tax advisor, as individual tax situations will vary. Securities offered through Capulent, LLC, Member FINRA, SIPC.

 

 

Coffee mug, eyeglasses, and laptop sitting on table

GET OUR FREE EBOOK!

Sign up for our newsletter and receive a free copy of our ebook.

Includes tips on how to:

  • Increase Cash Flow Potential
  • Lower Your Closing Risk
  • Diversify Your R/E Portfolio
This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.