1031 Exchange Rules and Limitations

1031 exchange rules and limitations. This reader wants to know if they can use a 1031 exchange to buy a new investment property with other investors.

Q: Are there options for a 1031 Exchange where you would be a property owner with other people? For example, if you bought an office building, retail center or apartment complex with partners? I recently sold a condo for around $225,000 and am thinking about what I can do now with the proceeds.

1031 Exchange Rules and Limitations

A: A 1031 exchange (which is listed under Section 1031 of the IRS code) is a like-kind exchange, according to the IRS. It is used by investors to buy and sell similar investments while postponing taxes on the profits generated along the way. According to the IRS, under the Tax Cuts and Jobs Act, Section 1031 now applies only to exchanges of real property and not to exchanges of personal or intangible property.

For real estate investors, using a 1031 exchange means you are selling one piece of real estate (a home, office building, retail center, warehouse, etc.) for another, but the properties don’t have to be identical. For example, you don’t have to swap a rental property for another rental property. However, the IRS says an investment property located in the U.S. is not like-kind to even an identical property located in a foreign country.

There are also very specific rules around using a Section 1031 exchange. The IRS code Section 1031 allows you to sell the existing property and defer the payment of all taxes on that sale, but you must identify a replacement property within 45 days of selling the existing property. You then must close on the new property no later than 180 days following the sale of the property.

The rules for selling and buying investment properties within the context of a 1031 exchange can be quite complex and we can’t go into all of the details here. Just know the dates are immovable and unless you’re serving the military in a war zone, you can’t get an extension. You’ll have to consult further with a 1031 specialist to make sure you don’t blow any dates or requirements.

Can You Use a 1031 Exchange to Buy a New Investment Property with Other Investors?

Your question seems to imply that you want to buy a new investment property with other investors. You can do this in the context of a 1031 exchange, but it can get complicated. For one, you’ve already sold your condominium for $225,000. This would mean that your share of ownership in the new investment property must be at least equal to or greater than the $225,000 value of your former condominium.

Also, the condo you sold must have been an investment property. That means the condominium wasn’t your personal residence and you owned it for investment purposes (i.e., it was rented out). If that’s the case, when you sell the investment property, you need to set up a version of a 1031 exchange known as a “deferred exchange.” You set up the deferred exchange usually with a company that specializes in 1031 exchanges.

An Example

Here’s an example of how this might work: Let’s say you and some investor friends want to buy an apartment building together and the building is worth $1 million. In this example, you and your friends would have to buy the building as tenants in common — meaning that you would own a certain share of the building and your friends would own the balance. If you purchased a one-third share in the building, your share would be worth around $333,333 of the building and would exceed your $225,000 sales price. You would be a one-third owner of the building.

Finally, you have to remember that your ownership in the new building should mirror the ownership in your old building. This means that if you owned the old condominium in your name, you need to own your one-third interest in the new building in your own name as well. And, you can’t set up a limited liability company (LLC) to own the new building and own your one-third share that way. Your ownership interests must be held in the same way.

COVID-19 and Your 1031 Exchange

One last item to consider with the COVID-19 situation we face. As of the date that we wrote this column, the IRS has not granted an extension on the 45 days for designation or the 180 days to close. If you closed on the 10th of March, that was the 70th day of the year. You’ll have until April 24, 2020 to designate your replacement properties. Then, you’ll have to close on the replacement or replacement properties no later than September 4, 2020.

We mentioned that you can buy one or more properties to replace the one you sold but we know that it’s likely (given the price point) that you may only buy one property to satisfy the replacement rule. But remember, the dates are firm dates unless the IRS allows extensions due to the current situation with the virus.

(Due to the COVID-19 pandemic, the IRS has delayed the date for both filing your federal tax return and paying any taxes owed to July 15, 2020. Announcements about stimulus payment checks, Coronavirus paid leave and other COVID-19 relief can be found at https://www.irs.gov/coronavirus.)

Additional Considerations

One last thing to mention is that some companies specialize in giving investors the ability to buy into a type of property that currently exists. For example, a company may specialize in tenancy in common arrangements and handle the ownership of a portfolio of buildings. If you show up with $225,000, they may be able to place you in one of those properties with an ownership interest equal to the amount you invested. (Be sure to ask a lot of questions, including how you can dispose of your share if you decide to purchase something else and what fees are involved, and then make sure you speak with a smart real estate attorney who can review the documents before you sign.)

For some real estate investors, this sort of investment hits the mark while others prefer to control their own real estate investments.