1031 Exchange Qualified Property
The property you plan to dispose of in your 1031 Exchange is referred to as the relinquished property. The property you wish to acquire to complete your 1031 Exchange is called the replacement property. In a single exchange, you may have more than one relinquished property and/or more than one replacement property. Both the relinquished property and the replacement property, according to IRS, must be properties held for investment or productive use in a trade or business. A trade or business includes rental property, but also could include the location of your business such as a store or manufacturing plant.
Personal residence property (property you live in) is not qualified 1031 Exchange property. You can also have a mixed use property, i.e., part is your home and part is business or investment such as a duplex where you live in one half and rent the other half, or a farm where most of the land has been productively used in a farming business but your home is also on the property. Any real estate (vacant or improved) is “like kind” for 1031 Exchange purposes, except personal residence property.
The character of property can change so it is qualified for 1031 Exchange at one time and disqualified at another time. For example, if you use your vacation home for awhile but then change it to a rental, it will then qualify for 1031 Exchange. Likewise, there is nothing wrong with buying a replacement property, renting it for awhile and then moving in. In other words, as long as your intent was to use the property for rental when you received it, there is nothing wrong with changing your mind later and living in it as your primary or second home.
Replacement properties can run the gamut from a vacant lot or single family rental property to a huge real estate development. Large companies use 1031 Exchanges to avoid tax on profit and depreciation recapture on multi-million dollar manufacturing plants, office buildings, shopping centers and similar large projects. Small investors may be exchanging a house, condo or vacant lot worth less than $100,000. The benefits of 1031 Exchange are available to all people who own property that is qualified for 1031 Exchange, small to large.
In addition to full ownership properties from small to large, you can also buy a percentage (partial) interest in real estate as a replacement property. In other words, you can be a co-owner with someone else who is doing an exchange or simply wishes to make a new real estate investment, or someone who already owns a property that would qualify for 1031 Exchange and who is willing to sell you a share of it. This is called tenants in common ownership and the deed to the co-owners might show them as, for example, “John Smith as to an undivided 30% interest and James Jones as to an undivided 70% interest, as tenants in common.” If someone is willing to sell you a share of property he already owns, your deed from him would transfer, for example, “a 25% undivided interest in (followed by the property’s legal description).” However, special rules apply to full interest or partial interest transfers from someone who is related to you.
You may ask, although someone wants to buy my relinquished property, how do I find a replacement property? There is no easy answer. Generally, finding a replacement property is the same as prospecting for any potential real estate investment. You can use the internet, engage a buyer’s broker, search the newspapers, etc. Everyone has a different level of sophistication regarding these things, and each person is left to his own devices and resources, and the resources of any real estate professionals contacted or retained to assist.
Because of potential difficulty finding, identifying and closing upon replacement property within the identification and closing deadlines, reverse exchanges where you buy your replacement property first have become quite popular (see Reverse Exchanges elsewhere in this website).
There are some national companies who specialize in making 1031 Exchange replacement properties available. Some specialize in full ownership long term net leased properties such as drug stores, restaurants and other kinds of properties where an often nationally recognized company sells and leases back its store, restaurant, etc. (land and building) usually for a long term. Others specialize in offerings where (usually referred to as DSTs) they will sell you a percentage (partial) interest in a large shopping center, office building or other office, retail or mixed use property. Some companies do both. Of course, with a net leased property, the tenant normally pays expenses on the “triple net” basis and the landlord (you, the exchanger, if you purchase one of these as a replacement property) receives a rent check each month, usually for many years. DST programs offer professional management and potential periodic payments of cash flow to the owners, with the upside chance of profit on sale of the property. However, DST investments are generally illiquid, and DST investment cash flow/rental income and property appreciation are not guaranteed and there is a potential of loss of principal invested. Both net lease and DST programs are attractive to some exchangers because, among other things, they are conveniently available and usually free of management headaches because of the relatively passive nature of the investment. However, it should be remembered that DST co-owners do not have direct control over day-to-day property management decisions.