ANSWER THIS QUESTION FIRST: Do the properties I am selling
and buying qualify for exchange?
Section 1031 of the tax code says real property held for productive use in a business or trade, or for investment, qualifies for exchange (this is called the qualified use requirement). That means your primary residence does not qualify and neither does property held primarily for sale and accounted for as inventory. So, if you purchased a property and are planning to flip it, the property does not meet the qualified use requirement and the transaction will not qualify for tax deferral under 1031. However, an investment property you have owned for longer than the two year period immediately preceding the sale will.
TIP: It’s a good idea to own a qualified property for two years or longer before selling it in an exchange. If own the property for greater than two years and the IRS audits your exchange, it is unlikely they will question your investment intent for the property based on this length of ownership (however, please note that length of time of ownership is not the only element the IRS would consider when it comes to the qualified property analysis). This doesn’t mean you cannot exchange a property you have owned for less than two years and, in fact, many investors will wait only one year, or a year and a day or a year which straddles two tax years. But the less time you own the relinquished property before selling it, the more challenging it might be to convince the IRS of your investment intent.
What about personal residences?
Typically, a taxpayer’s primary residence does not qualify for 1031 exchange treatment. There are, however, various exceptions to this general rule.
- If a portion of the primary residence or second home is either held for investment or held for productive use in a trade or business, then that portion may qualify for a 1031 exchange. A taxpayer may have a split transaction whereby a portion is subject to 1031 tax-deferral and a portion of the property is subject to the personal residence tax exemption under IRS Code Section 121.
- A taxpayer may vacate his or her primary residence and convert the former residence into a property held for investment or used in a productive trade or business. The converted property should qualify for a 1031 exchange, although it is not clear exactly how long the property must be held for investment or used in a productive trade or business in order to qualify.
What about second homes and vacation homes?
As a general rule, a taxpayer’s second home or vacation home does not qualify for 1031 exchange treatment since “personal use” property does not meet the held for investment or held for use in a productive trade or business requirement. Also, the taxpayer will not be eligible for the personal residence exclusion under IRS Code Section 121 as noted above.
A property is generally considered to be a second home if the taxpayer uses the property for personal purposes for a number of days which exceeds the greater of 14 days or 10% of the number of days during the year for which the property is rented at a fair market value.
However, a facts–and-circumstances analysis may reveal that a second home or vacation home has been held for investment in satisfaction of the qualified use requirement, and this investment intent may indeed outweigh the taxpayer’s personal use. The facts and circumstances particular to the taxpayer’s treatment of the property are critical to this “held for” analysis.
ANSWER THIS QUESTION SECOND: What type of exchange makes
the most sense for my situation?
If you are selling your relinquished property first, and then buying another property after the sale to replace it, you are doing a FORWARD EXCHANGE.
If you are purchasing replacement property first, and then selling your relinquished property afterward, you are doing a REVERSE EXCHANGE.
If you are using exchange funds to build improvements on property you purchase in the exchange, you are doing a CONSTRUCTION EXCHANGE. A construction exchange can be a forward exchange or a reverse exchange.
If you are using exchange funds to build on property you or a related party already owns, you are doing a CONSTRUCTION LEASEHOLD EXCHANGE. A construction leasehold exchange can be a forward exchange or a reverse exchange.
More about complex exchanges (reverse exchanges, construction exchanges and leasehold exchanges):
Complex exchanges require a high degree of expertise and experience. There are several types of complex exchanges and we are an expert in assisting with all of them.
Reverse exchanges, construction exchanges and leasehold exchanges require a complex exchange structure where you will not own the replacement property until the exchange ends. Instead, the replacement property will be “parked” with a single-member LLC which is a disregarded entity where our holding company is the sole member. Such an entity is called an exchange accommodation titleholder (“EAT”). The taxpayer will acquire the replacement property at the end of the exchange when we assign the sole membership interest in the EAT to him/her, satisfying the same taxpayer requirement for exchanges described above. The same taxpayer requirement means that the taxpayer selling the relinquished property must be the same taxpayer purchasing the replacement property. The exchange does not work if the seller of the relinquished property and purchaser of the replacement property are different taxpayers.
Strategic 1031 Exchange Advisors, LLC, a Georgia limited liability company, is a qualified intermediary for 1031 exchanges only. It is not an accounting firm, law firm or registered investment professional and therefore is not qualified to give accounting, tax, legal or investment advice, and, further, cannot act in an agency capacity on behalf of its clients. This website is for informational purposes only and does not and is not intended to constitute accounting, tax, legal or investment advice. We advise you to consult with your accountant, attorney and investment professional on all matters related to your exchange.