1031 Exchange Replacement Property Options
A successful 1031 exchange involves the sale of property held for use in a trade or business, or held for investment, and exchanged for replacement property of “like-kind”.
The like-kind requirement is very broad. Generally, any real estate can be exchanged for any other real estate, as long as it is held for investment purposes or used in connection with the owner’s business. This means that investors can think broadly as they evaluate current market conditions and replacement property options. Let’s look at a few examples:
Different asset class – Commercial property can be exchanged for residential property and residential property exchanged for commercial. Additionally, any asset class is like-kind to any other asset class so a retail center can be exchanged for industrial, multi-family, hospitality, or one or more single family homes.
Different state - Property sold in any state can be exchanged for property in any other state in the United States. Real estate located outside the United States (i.e. “Foreign” real estate) is not like-kind to real estate within the 50 states, even if it is located in an affiliated commonwealth or territory. The U.S. Virgin Islands are an exception to the rule, as are Guam and the Northern Mariana Islands. In some cases, Foreign real estate can be exchanged for Foreign real estate.
Triple net (NNN) leased property – Investors looking for commercial property with less management responsibility can trade into a property with a triple net lease. A triple net leased building has an investment grade tenant who is obligated to pay all expenses related to the property including real estate taxes, insurance, and maintenance.
Delaware Statutory Trust (DST) - A DST investment is typically a real estate investment that is held in a special entity called a Delaware statutory trust. DSTs must be structured properly to meet the IRS requirements set out in a ruling issued by the IRS (Revenue Ruling 2004-86). Provided the DST is structured properly, the taxpayer can acquire an interest in the DST and it is just like buying a piece of real estate directly. Each owner owns a beneficial interest in the DST, and the DST owns one or more properties.
Vacant lot versus income producing - Unimproved property is like-kind to improved property, so vacant land can be exchanged for income producing residential or commercial rental property.
Long term Leasehold – A lease with at least 30 years remaining (including extensions) is like kind to a fee interest.
What does not qualify as like kind replacement property?
Personal Property – Real estate is not like kind to personal property, so you are not able to sell land and buy equipment or an airplane (even if they would be used for your business) and receive tax deferral treatment under IRC 1031.
Partnership Interests – While a partnership can complete a 1031 Exchange, under IRC § 1031(a)(2)(D), actual partnership interests are not exchangeable.
REITS - Investors who invest in REITs own shares of stock and do not own the real estate directly. Shares of stock are personal property and therefore not like kind to real property and Section 1031 specifically states that stock cannot be traded in a 1031 exchange.
UPREITS - Some REITs own their real estate in an UPREIT or umbrella partnership. If the REIT is interested in buying your real estate, you can contribute the real estate to the UPREIT in exchange for operating units (OP Units) of the UPREIT. This is not a 1031 exchange, but the transaction may be structured to be tax deferred under IRC Section 721. Now you own OP Units which give you the right to receive cash flow that is equivalent to owning shares of the REIT stock. Eventually you can convert those OP Units to cash or REIT shares, although when you do so, it will likely be a taxable event.
Even though a transaction meets the like-kind requirement, you must still meet all the other requirements of §1031 (i.e., holding; purpose) before a transaction can qualify for tax-deferred treatment. Contact your local First American Exchange office whenever you intend to dispose of real property used in your trade or business, or held for investment. We can help you harness the power of tax-deferral.