Does a 1031 exchange have to be an investment property?

Question

Is it necessary for a property involved in a 1031 exchange to be held for investment or productive use in a trade or business, rather than for personal use or as a primary residence?

ARTE's Answer

A 1031 exchange, as outlined in Section 1031 of the Internal Revenue Code, is a powerful tax-deferral strategy that allows investors to defer capital gains taxes on the sale of a property by reinvesting the proceeds into a like-kind property. The key requirement for a property to qualify for a 1031 exchange is that it must be held for productive use in a trade or business or for investment purposes. This means that the property involved in the exchange cannot be personal-use property, such as a primary residence or a vacation home that is not rented out.

The term "investment property" in the context of a 1031 exchange refers to real estate that is held for the purpose of generating income, appreciation, or both. This includes properties like rental homes, commercial buildings, land held for investment, and other types of real estate that are not primarily used for personal enjoyment.

To illustrate how a 1031 exchange works with investment properties, let's consider an example using our services at Deferred.com as the qualified intermediary:

  1. Sale of the Relinquished Property: You sell your rental property for $400,000. To defer the capital gains tax, you engage Deferred.com as your qualified intermediary. We facilitate the exchange by holding the proceeds from the sale.
  2. Identification Period: Within 45 days of selling your rental property, you must identify potential replacement properties. In this case, you identify the commercial building as your desired replacement property.
  3. Exchange Period: You have 180 days from the sale of your relinquished property to close on the purchase of the replacement property. You use the $400,000 proceeds held by Deferred.com as a down payment on the $600,000 commercial building, and you finance the remaining $200,000 through a mortgage.
  4. Completion of the Exchange: By reinvesting the entire proceeds from the sale of your rental property into the commercial building, you successfully defer the capital gains tax on the $200,000 gain from the sale of your original property.

At Deferred.com, we offer a No Fee Exchange, which means you can save money on the transaction while ensuring compliance with IRS regulations. Our role as a qualified intermediary is crucial in maintaining the tax-deferred status of the exchange, as we handle the funds and ensure that you do not have constructive receipt of the proceeds.

It's important to note that while the properties involved in a 1031 exchange must be held for investment or business purposes, they do not have to be of the same type. For example, you can exchange a rental home for a commercial building, as long as both properties are held for investment. The key is that they must be "like-kind," which refers to the nature or character of the property, not its grade or quality.

If you have any further questions about how a 1031 exchange can work for your specific situation, feel free to reach out to us at Deferred.com. We're here to help you navigate the complexities of real estate tax strategies and maximize your investment potential.

Have more questions? Call us at 866-442-1031 or send an email to support@deferred.com to talk with an exchange officer at Deferred.

Deferred's AI Real Estate Tax Expert (ARTE) is a free research tool. Trained on 8,000+ pages of US tax law, regulations and rulings, ARTE outperforms human test takers on the CPA exam. This is page has ARTE's response to a common 1031 Exchange question and should not be considered personalized tax advice.

Sources

Learn More

See more frequently asked questions about 1031 exchanges

What happens to passive losses in a 1031 exchange?
How are passive activity losses treated when conducting a 1031 exchange, and what are the implications for deferring or recognizing these losses in the context of the exchange?
How much to reinvest with 1031 exchange?
What is the minimum amount I need to reinvest in a replacement property to fully defer capital gains taxes in a 1031 exchange, and how do factors like closing costs, existing mortgages, and potential boot impact this reinvestment requirement?
Que es un 1031 exchange?
What is a 1031 exchange, and how does it work in terms of deferring capital gains taxes on the sale of investment or business-use properties?
How to avoid 1031 exchange?
What are the alternatives to a 1031 exchange for deferring or minimizing taxes on the sale of investment property, and under what circumstances might these alternatives be more beneficial than pursuing a 1031 exchange?
How does a 1031 exchange help in diversifying a real estate portfolio?
How can utilizing a 1031 exchange facilitate the diversification of a real estate portfolio by allowing an investor to defer capital gains taxes while exchanging properties for different types of real estate assets, thereby enabling the investor to strategically reallocate their investments into various sectors or geographic locations within the real estate market?