Eligibility for a 1031 Exchange: Who Can Participate?

A 1031 exchange is a strategy utilized by real estate investors to postpone the payment of capital gains taxes, allowing them to reinvest the full proceeds from the sale of an asset. Fortunately, the Internal Revenue Service (IRS) has established guidelines and regulations that, if meticulously adhered to, permit taxpayers to engage in this process.

The requirements for a successful 1031 exchange are as follows:

Like-Kind Properties: The assets involved in the exchange must be of "like-kind." While the definition of "like-kind" was broader before the Tax Cuts and Jobs Act (TCJA), which imposed limitations, the exchange now primarily applies to business properties. However, almost any income-producing property can qualify. For instance, you can sell a residential rental property and reinvest in an office building, or sell an office building and reinvest in retail properties. The exchange allows for flexibility in altering your real estate portfolio's composition, focusing on different geographic regions or sectors to maximize investment potential.

It is important to note that personal-use properties, such as primary residences or second homes, do not qualify for a 1031 exchange.

1. Qualified Intermediary (QI): To facilitate the exchange, a Qualified Intermediary (QI) must be involved. The QI is an independent third party responsible for holding the proceeds from the sale of the relinquished property and ensuring they are properly transferred to acquire the replacement property. Their involvement is crucial to maintain compliance with IRS regulations and avoid direct receipt of the funds by the taxpayer, which would disqualify the exchange.

2. Timeline: Strict timelines must be followed during a 1031 exchange. The taxpayer has 45 days from the sale of the relinquished property to identify potential replacement properties. Subsequently, the acquisition of the replacement property must be completed within 180 days from the sale.

1031-exchange eligibility requriements IRS regulations, and tax deferrals.

Restrictions

There are several important restrictions to be aware of when engaging in a 1031 exchange:

1. Value and Debt Replacement: One key requirement is that the investor must replace both the value and the debt level of the relinquished property. For example, if you sell a property worth $400,000 with a mortgage of $300,000, you need to acquire one or more new assets with a combined value and debt equal to or greater than those amounts. Failure to meet this requirement can result in disqualification from the exchange and potential capital gains tax liability.

2. Timeline: Once the relinquished property is sold, the investor has a tight timeframe to complete the exchange. Within 45 days of the sale, the investor must formally identify potential replacement properties. The acquisition of the replacement property must then be completed within 180 days, including the initial 45-day identification period. Meeting these strict deadlines is crucial to maintain eligibility for the tax-deferred exchange.

3. Options for Replacement Property Identification: There are three options available for successfully identifying and acquiring replacement properties:

Option 1: Identify up to three potential replacement properties, without any restrictions on their individual or total value. Ultimately, the investor must purchase one or more of these properties and ensure that both the value and debt level of the relinquished property are replaced.

Option 2: Identify an unlimited number of properties, but their combined value cannot exceed 200% of the original asset's value. Similar to the first option, the investor must purchase one or more of these properties to satisfy the value and debt replacement requirements.

Option 3: Identify any number of properties during the allowable period, but the investor must acquire properties with a combined market value of at least 95% (equal to or greater than) the cost of the relinquished property. By meeting this threshold, the investor ensures the replacement of both value and debt.

1031-exchanges-new-york-tax cuts and jobs act 2023 resources.

“Can I just do this myself?”

No, you cannot handle a 1031 exchange on your own. According to the rules governing these exchanges, you are required to work with a Qualified Intermediary (QI) or Exchange Accommodator. The role of the QI is to oversee the transaction and ensure compliance with the necessary regulations. They act as a third-party facilitator, safeguarding the proceeds from the sale and managing the exchange process.

The QI establishes a separate account to hold the funds from the sale of the relinquished property, ensuring that you, as the investor, do not have direct access to the proceeds. They also receive the formal identification of potential replacement properties from you and assist in the acquisition of the identified replacement property.

Furthermore, the QI takes charge of collecting and organizing the required documentation throughout the exchange process. Their expertise in the rules and regulations surrounding 1031 exchanges is crucial to ensure that the transaction is conducted correctly.

Typically, the QI charges a flat fee for their services. It is important to select a knowledgeable and experienced QI to handle your exchange properly. Mishandling the transaction or failing to comply with the rules can result in the imposition of capital gains taxes and potential depreciation recapture charges.

Therefore, it is strongly advised to work with a Qualified Intermediary when engaging in a 1031 exchange to ensure a successful and tax-efficient transaction.

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

Is a 1031 Exchange Allowed into a Qualified Opportunity Zone?

The '1031 Exchange' or the 'Like-Kind Exchange' is a provision outlined in the 26 U.S. Code § 1031 that has a history dating back almost a century. Initially established as a means for farmers to comprehend land boundaries, the code now serves as a tool for investors to defer capital gains taxes on real estate investments. By permitting the exchange of a property into other like-kind investments, the 1031 Exchange offers a means to defer tax implications.

The Qualified Opportunity Zone Program (QOZP) was introduced as a component of the Tax Cuts and Jobs Act of 2017 with the goal of promoting investment in lower-income communities by offering tax benefits for capital gains generated from asset sales. While both the 1031 Exchange and the QOZP provide tax deferral for asset sales, they differ significantly in their objectives and requirements.

Therefore, it is not possible to utilize the 1031 Exchange to invest in a Qualified Opportunity Zone. This is because the 1031 Exchange requires a like-kind exchange between assets, and exchanging real estate property for a Qualified Opportunity Fund does not fit the definition of like-kind. Furthermore, the significant disparities between the two programs make a direct exchange from one to the other challenging to achieve.

Major Differences

Upon a more in-depth analysis, it becomes clear that there are several significant differences that make exchanging real property for a Qualified Opportunity Fund (QOF) not feasible.

Qls vs. QOFs. One of the key differences is the treatment of gains and forward rolls. In a Qualified Opportunity Zone investment, the investor places their capital gains into the fund, whereas with a 1031 Exchange, the investor must retain their original investment, capital gains, and debt. On the other hand, in a QOZ investment, the investor has the freedom to retain their original basis and use it as they see fit.

These differences highlight the distinct nature of the two programs and why it is not possible to directly exchange real property for a Qualified Opportunity Fund.

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Timelines and Deadlines. Another key difference between the two programs lies in the timelines and deadlines involved. Although both programs have deadlines, they are significantly different.

In the case of a 1031 Exchange, the investor has a 45-day window to identify a replacement property and must complete the like-kind exchange within 180 days. On the other hand, a QOZ investor must invest their gains into a Qualified Opportunity Fund within 180 days.

However, if an investor is unable to find an appropriate like-kind property within the 45-day deadline for the 1031 Exchange, they may still invest the capital gains from the asset sale into a Qualified Opportunity Zone as long as they do so within the 180-day window for realizing the gains.

Holding Periods and Step-Ups. Another key aspect to consider is the difference in step-ups and holding periods between the two programs. Qualified Opportunity Zone investments often come with a tax advantage that is tied to a specific timeline.

Specifically, if an investor holds their investment in a Qualified Opportunity Fund for a minimum of 10 years, they will not be taxed on the portion of the property gain generated by the fund. This is because the investor will receive a step-up in basis on the property, effectively increasing it to the fair-market value.

This feature is unique to the Qualified Opportunity Zone Program and highlights the advantages that can be gained through investing in a Qualified Opportunity Fund. The ability to receive a step-up in basis and avoid paying taxes on the portion of the property gain further underscores the difference between the 1031 Exchange and the Qualified Opportunity Zone Program.

Clear Your Investment Path: Understanding Your Target Investment

Both the 1031 Exchange and the Qualified Opportunity Zone Program provide tax-deferral benefits to investors, but they differ greatly in terms of their purposes and requirements. As a result, exchanging real estate property directly into a Qualified Opportunity Fund is not feasible. It would be an unfair comparison to attempt to compare these two distinct investment opportunities.

It's important to note that neither program is inherently better than the other. The most suitable option for an investor will depend on factors such as their portfolio structure, timing, and investment goals. The key is to have a clear understanding of the distinct differences between these programs, so that investors can make informed decisions that align with their investment objectives.

Investing in Qualified Opportunity Zone (QOZ) properties and real estate securities is not without its challenges and hazards. These investments are vulnerable to various risks, including reduced liquidity, empty rental units, fluctuations in market conditions and competition, lack of historical performance, fluctuations in interest rates, the threat of new market entrants causing a decline in rental prices, risks associated with owning and managing commercial and multi-family properties, short-term leases in multi-family properties, financing risks, potential tax implications, general economic uncertainties, development-related risks, extended holding periods, and the possibility of losing all of the invested principal.

General Disclosure

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

Opportunity Zone Disclosures:

Opportunity Zones (“OZ”) are speculative. OZs are newly formed entities with no operating history. There’s no assurance of investment return, property appreciation, or profits. The ability to resell the fund’s underlying assets is not guaranteed. Investing in OZ funds may involve higher risk than investing in other established real estate offerings.
Long-term. OZ funds are illiquid and return of capital and realization of gains, if any, from an investment will generally occur only upon partial or complete disposition or refinancing of such investments.
Limited secondary market. Although secondary markets may provide a liquidity option in limited circumstances, the amount you will receive is typically reduced.
Difficult valuation assessment. The portfolio holdings in OZ funds may be difficult to value. As such, market prices for most of a fund’s holdings will not be readily available.
Default consequences. Meeting capital calls to provide pledged capital is a contractual obligation of each investor. Failure to meet this requirement in a timely manner could have adverse consequences including forfeiture of your interest in the fund.
Leverage. OZ funds may use leverage in connection with investments or participate in investments with highly leveraged structures. Leverage involves a high degree of risk and increases the exposure of the investments to factors such as rising interest rates, downturns in the economy, or deterioration in the condition of the assets underlying the investments.
Unregistered. The regulatory protections of the Investment Company Act of 1940 are not available with unregistered securities.
Regulation. It is possible, due to tax, regulatory, or investment decisions, that a fund, or its investors, are unable to realize any tax benefits. Evaluate the merits of the underlying investment and do not solely invest in an OZ fund for any potential tax advantage.

Maximize Benefits of a 1031 Exchange: Tax Straddle Strategy

It is a requirement of a 1031 Tax Deferred Exchange that the purchase of the replacement property must occur within 180 days of the sale of the relinquished property in order to defer capital gains tax on the profits. However, if the 180-day period extends into the next tax year, it raises the question of in which tax year the capital gains tax will be due.

Specifically, if the 180 days "straddles" two years, the question arises as to whether the capital gains tax is due in the year the relinquished property was sold or the following year.This flexibility allows the seller to align the payment of capital gains tax with their personal financial situation and goals.

Basics of a 1031 Tax Deferred Exchange

The 1031 Tax Deferred Exchange provision in the IRS Tax Code incentivizes real estate investment by allowing investors to defer capital gains taxes while acquiring more valuable properties and rental income. Through a series of purchases and sales, an investor can swap one property for multiple or vice versa. However, it is important to note that the tax entity that sells the property must be the same as the one that buys it.

The Internal Revenue Service (IRS) specifies precise requirements that an exchange must follow in order to be eligible for a 1031 exchange. Any violation of these guidelines could result in capital gains being paid by the investor.

Investors must adhere to a tight timetable after selling the initial property, sometimes referred to as the "relinquished property," in order to complete a 1031 exchange. After 45 days, an investor has 180 days to find a "replacement property" and close on it. Both dates are determined starting on day zero, which is the day the property was given up for sale.

As long as their decision complies with one of three criteria outlined by the IRS, investors are free to choose as many properties as they want. The properties can be of different types, for example, a primary residence can be sold and replaced with a commercial property or a multi-family building can be exchanged for a single family home to be used as a vacation rental.

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The rundown:

● In a 1031 exchange, the property sold (referred to as the "relinquished property") and the property bought (referred to as the "replacement property") must be of "like-kind."

● A Qualified Intermediary (QI) is used to handle the proceeds from the sale and purchase of the properties. The QI is a third party that is specifically established for this purpose, and no money from the sale goes to or is handled by the seller.

● Within 45 days of selling the "relinquished property," the seller must submit a list of up to three potential "replacement properties" or properties valued at up to 200% of the sale price of the relinquished property to the QI.

● From this list, the seller must choose the “replacement property” or properties to purchase.

● The seller has 180 days from the closing of the "relinquished property" to close on the "replacement property."

● The purchase price of the "replacement property" must be equal to or higher than the sale price of the "relinquished property in order to fully defer all taxes

● If all profits from the sale of the "relinquished property" are used for the purchase of the "replacement property," and all debt replaced, if any, no capital gains tax is due (deferred).

● If the seller does not utilize all of the profits from the sale of the "relinquished property" for the purchase of the "replacement property," capital gains tax is only due on the portion not used.

“The Tax Straddle Strategy”

In the case of a 1031 exchange where the sale of the "relinquished property" closes after early July, the 180-day period in which the closing of the "replacement property" must occur may fall into the next calendar year. If the closing does not occur within this 180-day period, the exchange is considered to have failed.

The proceeds from the sale of the "relinquished property" are returned to the seller from the Qualified Intermediary and capital gains tax is due on any profits from the sale of the "relinquished property". However, the IRS allows the seller to choose in which tax year they will be subject to tax, either the year of the sale or the year of the failed purchase, as the 180-day period "straddles" two tax years.

The ability to choose when to pay capital gains taxes can be a significant advantage for the seller in a 1031 exchange. In the event of a failed exchange, where the closing of the "replacement property" does not occur within the 180-day period, the seller has the flexibility to make a strategic decision that aligns with their financial goals.

They can either pay capital gains taxes for the year of the sale of the "relinquished property" or choose to defer the taxes and use the proceeds for any purpose for an entire calendar year, before paying the taxes in the year of the failed exchange. This flexibility allows the seller to potentially invest or save the proceeds for a year, or even to use them for other real estate investments, before paying taxes on the profits of the sale of the "relinquished property”.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. 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.

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 is no guarantee that any strategy will be successful or achieve investment objectives;
Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
Change of tax status – 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;
Potential for foreclosure – All financed real estate investments have potential for foreclosure;
Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

The IRS: 7 Deadly Sins of DSTs

In order to postpone and possibly prevent paying capital gains tax on the sale of other investment real estate holdings, investors frequently turn to DSTs, or Delaware Statutory Trusts. A DST enables investors to use a 1031 exchange into a DST that is actively managed by a qualified third-party, as opposed to a standard 1031 exchange from one wholly-owned property to another. As opposed to owning real estate that needs their active management, this enables the investor to play a more passive, supporting role.

In a diverse portfolio of institutional-grade real estate, investing in a DST may offer investors a fantastic, hassle-free option to generate monthly passive income.

However, DST investments follow the same stringent guidelines as conventional 1031 swaps. The IRS (ruling 2004-86) proposed the "seven deadly sins" of DSTs in order to explain the laws and standards governing DSTs. These regulations set strict parameters on how DSTs must function and restrict the trustees' authority.

Each of the seven deadly sins of DSTs is described in detail in this article.

After a DST offering closes, neither current nor new investors are allowed to contribute funds to the DST in the future.

In contrast to other real estate syndications or funds, a DST offering that has closed may not issue capital calls or ask for additional contributions from investors. For this reason, investing in a DST entitles you to a pro rata portion of property ownership based on the amount of your initial investment. Any further investments might alter ownership proportions, which consequently might reduce someone's ownership part. There are no more contributions accepted after the DST offering closes since doing so might affect investors' claims to the DST assets.

The Trustee of a DST is not permitted to take out additional loans or modify the conditions of current loans.

The sponsor of a DST is obligated by law to declare the loan amounts connected with the assets held in that DST prior to accepting investments. This enables potential investors to assess a portfolio's debt-to-income ratio as part of their due diligence process since the kind, interest rate, and terms of debt can affect investment returns. This choice precludes the sponsor from taking on additional debt or refinancing into a new mortgage that may otherwise affect the beneficiaries' interest because DST investors have very little control over investing decisions.

However, there is an exception to this rule. In the event of a tenant's bankruptcy or insolvency, the DST sponsor may be allowed to renegotiate loan conditions or take on extra debt, but only after extensive paperwork and scrutiny.

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A DST is unable to reinvest the money it receives from selling its real estate.

The IRS forbids a sponsor from reinvesting the earnings from the sale of the DST into new investment property, unlike real estate investment trusts, or REITs. Instead, the numerous DST beneficiaries must get a portion of the sale revenues. The DST's investors can then take their portion of the sales profits and either cash out completely or roll the winnings into another DST (via a new offering with the same sponsor or a different sponsor altogether). The capital gains of those who choose the latter will be liable to both state and federal taxes at that time.

The DST sponsor's ability to make capital upgrades is restricted, with the exception of those related to (a) routine repair and maintenance; (b) small, non-structural capital improvements; and (c) those mandated by law.

Any DST sponsor's ability to make enhancements is subject to IRS restrictions. The justification is that historically, certain sponsors have chosen to engage in enhancements that ultimately jeopardize the investment of the beneficiaries. This clause aims to safeguard investors from regrettable capital upgrades.

The DST may only reinvest cash reserves retained between distribution dates in short-term debt obligations.

The majority of DSTs have sizeable cash reserves on hand since DST sponsors are unable to acquire further funds or incur new debt once the offering closes. If necessary, these cash reserves might be used to fund more investments. However, the IRS only permits DST sponsors to invest cash in short-term loan commitments that can be quickly liquidated prior to the DST's next distribution date in order to prevent the use of cash in a speculative manner (such, for example, the above-mentioned fruitless capital improvements) (and therefore, is considered a cash equivalent).

One benefit of this clause is that it enables the DST sponsor to quickly implement strategic capital enhancements that raise the DST's value without jeopardizing the beneficiaries' investment.

Co-investors must receive monthly distributions of all funds, minus any necessary reserves.

Only "required" reserves can be kept on hand by a DST to pay for property management, urgent maintenance, repairs, and other unforeseen costs. If not, all cash earnings and sales proceeds from DST property must be distributed to investors on the dates agreed upon. This "deadly sin" aims to stop sponsor theft of funds and ensures that the DST beneficiaries consistently receive their rewards.

After the offering has ended, the DST sponsor is not permitted to renegotiate current leases or sign new ones.

The IRS forbids the sponsor from signing new leases or revising existing leases once a DST has ended. This is due to the fact that lease terms may significantly affect income and, consequently, investors' returns.

Using a Master Lease structure is one way for DSTs to "get around" this clause, if you will. The DST rents real estate to a "master tenant" under a master lease, who is then free to sign new leases or renegotiate existing ones with sub-lessors. The master lease offers some predictability to DST investors while giving the master tenant some latitude to modify leases for the property's advantage. This guarantees that the sponsor won't make dangerous leasing choices and places the onus on the master tenant to uphold the terms of the master lease.

In the event that a tenant files for bankruptcy or becomes insolvent, the sponsor may engage into a new lease or renegotiate the terms of the existing lease for that tenant.

Conclusion

DSTs could appear to be too controlled at first glance. The seven deadly sins of DSTs were merely implemented to safeguard investors, in actuality. Both the sponsor and the investors must strictly abide with these regulations. As a result, before investing in a DST, investors will want to thoroughly investigate any sponsor. Look for sponsors in particular who have the confidence to discuss the seven deadly sins of DSTs. It will be a good indication of the sponsor's expertise and aptitude if they can explain the nuances of these regulations.

Call us right away if you need assistance with a 1031 exchange. Investing your capital gains into a DST is a procedure that our staff would be pleased to help you through. Investors will discover that doing so is a terrific strategy to postpone paying capital gains tax while also switching from active to passive, diversified real estate investing.

General Information

This is neither a buy-side nor a sell-side solicitation of securities. The material presented here is purely for informational purposes and shouldn't be used to guide financial decisions. Every investment has the chance of losing some or all of the money. Future outcomes cannot be predicted based on past performance. Prior to investing, consult a financial or tax expert.

1031 Risk Disclosure:

* There is no assurance that any strategy will be effective or achieve investment goals; * Property value loss is a possibility for all real estate investments over the course of ownership; * Tax status may change depending on the income stream and depreciation schedule for any investment property. All funded real estate investments have the risk of going into foreclosure; adverse tax rulings may prevent capital gains from being deferred and result in immediate tax liability;
1031 exchanges are illiquid assets since they are frequently issued through private placement offerings. There is no secondary market for these investments. * Reduction or Elimination of Monthly Cash Flow Distributions - Similar to any real estate investment, the possibility of suspension of cash flow distributions exists in the event that a property unexpectedly loses tenants or suffers significant damage; * The impact of fees and expenses - The costs of the transaction could have an influence on investors' returns and even surpass the tax advantages.

Understanding a "Like-Kind" Exchange's Holding Period

Every investor must adhere to rigorous deadlines in order to effectively conduct a 1031 exchange. However, investors frequently inquire as to whether a property must be held for a specific period of time in order to be eligible for an exchange. Although the IRS hasn't stated a holding time specifically, a few factors could shed light on the matter.

During the 1031 Holding Period

How long an investor keeps a piece of property is known as the holding period. IRC Section 1031 does not specify the length of the holding period, as was previously indicated. Instead, it depends on the investor's goals.

No gain or loss shall be recognized on the exchange of property held for productive use in a business, according to the IRS.

"Even though properties vary in grade or quality, they are still of the same sort if they have the same nature or character.

Whether they are renovated or unimproved, real estate properties are often of a like kind. An apartment building would often be similar to another apartment building, for instance. However, real estate within the United States is not comparable to real estate outside.

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Recognizing Intent

The goal of Section 1031 is to make it possible for investors who have owned their property for a long time, particularly those who did so for income-producing purposes, to exchange it for another property that would serve the same function.

Since not all real estate is owned for the same purpose, not all of it is eligible. A primary residence is the most frequent case that should be considered. A primary residence does not qualify for an exchange since it is not "kept for productive use in a trade or industry or for investment." On the other hand, because they are held as investments, residential complexes, office and medical buildings, shopping malls, and single-tenant assets typically qualify.

In order to achieve a 1031 exchange, developers must overcome additional obstacles. Purchasing land, constructing a property, and then selling it for a profit frequently disqualifies a transaction from a 1031 exchange since a property must be held for investment purposes. In this case, the property was held for profit-making purposes rather than as an investment.

If investors are unsure whether the property will satisfy Section 1031, they should think about holding it for at least one year, if not two.

Even while the IRS has never explicitly said that there must be a minimum hold period, there have been instances where the IRS refused to allow an exchange because the owner's intent was ambiguous.

Investors who are unsure of their eligibility may choose to follow the two-year advice in general. However, as always, consult with a tax expert to receive their opinion on your specific case. The IRS referred to the two-year holding term in Private Letter Ruling 8429039 from 1984. The letter was written in response to a request for an exchange from an investor who wished to sell his property. Until 1981, the subject property served as the investor's primary residence. The investor leased out the property in 1983. The IRS granted the investor's request for a 1031 exchange in 1984, noting that keeping rental property for at least two years satisfies the holding period test required by Section 1031. But since a private letter ruling only applies to this specific instance, it may only be regarded as a general recommendation for 1031 exchanges.

The one-year holding consideration, on the other hand, was first proposed by Congress in 1989 as a requirement for a property to be eligible for a 1031 exchange. However, because this suggestion was never included in the Tax Code, it is not necessary. Instead, in order to determine whether a property would be eligible under Section 1031, tax professionals have referred to this idea.

The fact that the investment will appear on one's taxes as an investment property for two filing years if it is held for at least a year is another factor for the one-year holding period.

Nevertheless, these factors are but that—factors. In the past, the IRS has made choices on like-kind exchanges that do not support these ideas. For instance, in the case Allegheny County Auto Mart v. C.I.R. from 1953, the court allowed an investor to complete a 1031 exchange even though they had only owned the property for five days. However, in other cases, like Klarkowski v. Commissioner from 1967, an investor was still ineligible even after six years of ownership.

Is a vacation home acceptable?

Those who own property as a vacation home can often sell it and buy a new property via a 1031 exchange, however this is typically how commercial investors talk about 1031 exchanges. The vacation home must, however, have tenants, and it must be managed like a company. In addition, if the vacation home is purchased as the replacement property, the investment-related use of the property must continue. The property can usually not be turned into a primary residence within five years of the exchange.

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Additional 1031 Exchange Timelines That Are Important

Investors must be aware of and abide by the deadlines specified in Section 1031 in order to be eligible for a like-kind exchange.

There is no time limit on how long an investor has to sell an asset after it is put on the market. They can market it for one day or five years and sell it on or off the open market. In reality, they have the option to list the asset before deciding otherwise. Any gains are unrealized until the property is sold. A timetable doesn't begin until the property actually closes, and the investor may be liable for paying taxes on the realized gains.

An investor has 45 days to choose their replacement property and 180 days to close after the initial property, or surrendered property, closes. The 180-day period begins on the same day as the property's closure. With very few exceptions, every exchange that doesn't take place by these dates has all gains subject to taxation.

Speak with a Professional You Can Trust

Speaking with a trained professional is highly advised for anyone considering selling their real estate and buying a new property via a 1031 exchange. Many 1031 swaps have distinct looks. In addition to providing insight on the potential exchange, 1031 experts can lead investors to other 1031 exchange investment opportunities that might otherwise go unnoticed.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. 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.

1031 Risk Disclosure:

There is no guarantee that any strategy will be successful or achieve investment objectives;
Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
Change of tax status – 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;
Potential for foreclosure – All financed real estate investments have potential for foreclosure;
Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits