If you’re considering a 1031 exchange, you may wonder if exchanging a residential property for commercial real estate is possible. The answer is yes, with some caveats. Here’s what you need to know when it comes to converting 1031 exchange residential to commercial and how it works.
What is a 1031 Exchange?
First off, let’s review what a 1031 exchange is. A 1031 exchange allows an investor to defer capital gains taxes when selling an investment property and buying another one of equal or greater value.
This means that rather than pay capital gains tax on the sale of the original property, the investor can use that money toward purchasing their next property instead in what the IRS deems as an exchange. A 1031 exchange must involve an investment property (as opposed to a primary residence) and meet certain criteria to qualify.
Rules for 1031 Exchanges of Residential Property for Commercial Real Estate
While determining if it’s permissible to exchange a residential property for commercial real estate, two specific terms in the Internal Revenue Service (IRS) definition will determine whether this swap can be carried out:
- The residential property must be held for business or investment-oriented use and not primarily for personal purposes.
- The residential property must be comparable in type and quality.
Steps to Complete a 1031 Exchange Residential to Commercial
If you’re looking to complete a 1031 exchange from a residential property to a commercial property, here are the steps you need to take:
Identify the Relinquished Property and List it for sale
Although it may seem common knowledge, investors holding multiple properties must determine which of those they wish to sell. After selecting the property in question, a broker should be chosen, and the listing process can commence.
Identify a Replacement Property
The IRS states that you must identify a replacement property for your 1031 exchange within 45 days of the sale of the relinquished property, but this task is more complex. Locating an ideal replacement can be intensely competitive and challenging due to finding a desired price point and risk/return characteristics.
Close the Deal
The tax code stipulates that investors must close on their replacement property within 180 days of selling the relinquished one. Consequently, there is a great deal to accomplish quickly – from acquiring financing and title insurance and developing a management plan to transferring funds and executing closing documents.
Time management is crucial for maximizing success and working within a limited timeframe. By having everything ready beforehand, you can handle last-minute tasks.
When contemplating a 1031 Exchange, it’s wise to enlist the help of a qualified intermediary, as this complex and laborious transaction requires adherence to explicit rules. If these regulations are not followed, then the exchange may become taxable.
Can I Use a 1031 Exchange to Start a Business?
Yes, it’s possible to use a 1031 exchange to start a business. This exchange allows you to defer capital gains taxes by permitting funds from selling one investment property to be exchanged for another. The key is that the transaction must be executed specifically, as outlined in section 1031 of the Internal Revenue Code (IRC).
Generally, for an exclusion from capital gains tax to apply, investors must use the proceeds to purchase similar properties of equal or greater value within 180 days of completing their original sale. While it’s possible to use such exchanges to start a new business venture, it should only be done with a thorough understanding of how the IRC code applies and with guidance from legal and tax advisors.
Is a 1031 Exchange With a Primary Residence Allowed?
Contrary to popular belief, most primary residences and vacation homes are unsuitable for 1031 Exchanges because of the strict investment criteria imposed by the IRS. The same is true for all other types of personal property as well. To be considered “held for investment,” relinquished and replacement properties must meet specific qualifications outlined in 1031 Exchange regulations.
Why It Makes Sense To Exchange a Residential Property for a Commercial One
Investing in residential properties is an ideal way to begin a real estate investing journey. However, developing an entire portfolio of residential investment assets can take time and effort. That’s why exchanging one’s residential property for commercial real estate via 1031 Exchange makes perfect sense – there are numerous advantages, including:
Commercial real estate offers a single solution to managing multiple leasable spaces in the same building. For instance, a multifamily property can be leased with up to 20 units, while retail properties offer 50,000 SF of space. This proves much easier than handling residential properties that are often spread out over various regions.
Regarding residential investment properties, tenants are often individuals or families, and it can take some work to gain detailed knowledge of their fiscal health. In contrast, commercial tenants have audited financial statements that give greater insight into whether they can pay rent on time. This extra information makes selecting superior-quality tenants much simpler.
Long Term Leases
Three to five years are usually sufficient for most negotiations. Yet, in certain locations with anchor tenants like retail shopping centers who view their presence as strategically important could opt for much longer leases—upwards of 25 or 30 years.
What is Not Allowed in a 1031 Exchange?
Certain items are not allowed to be included in a 1031 exchange, such as primary residence and personal assets. The exchange must involve only investment or business-purpose assets; any real estate property not intended for use in an investment capacity cannot qualify for an exchange.
What is the Main Purpose of a 1031 Exchange in Commercial Real Estate?
1031 exchanges are an incredibly useful tax strategy for commercial real estate owners. This allows them to defer paying capital gains taxes and reinvest their profits into new properties without a tax burden. By exchanging like-kind properties of equal value, investors can use this method to purchase new properties without having the additional costs that higher taxes would bring.
Additionally, 1031 exchanges enable investors to avoid dealing with large capital gains bills when done correctly. This creates immense savings that can be put towards other parts of their business or investments.
Interested In Learning More?
Point Acquisitions specializes in simplifying the process of commercial property owners who would like to market and sell their assets on their terms. We understand that navigating traditional sales can be challenging, so we strive to make it easier by eliminating those common difficulties.
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