Amid tight inventory and surging demand, prices for residential real estate are soaring. In fact, Bloomberg reports that “demand is so fierce that almost half of US homes are selling within a week of hitting the market and annual price growth reached 12%, the highest figure since 2012.“
Given the rising prices, it is likely that sellers are booking big capital gains when a sale transaction is complete. This is a double edged sword. On one hand, they are happy because they made a profit. On the other hand, they are also likely to face a big capital gains tax bill. Fortunately, sellers of residential properties have an option to take their sales proceeds and use them in a specialized type of real estate transaction known as a “1031 Exchange.” Doing so will allow them to defer their tax liability indefinitely.
1031 Exchanges are commonly discussed in the context of exchanging two commercial real estate properties, but this isn’t always the case, as with a residential to commercial 1031 Exchange. A residential property – like a single-family rental property – can be used in a 1031 Exchange as long as it is held for investment purposes and is not a primary residence.
In this article, we discuss a unique type of 1031 Exchange in which a residential property is exchanged for a commercial property. Naturally, it makes sense to start by defining exactly what a 1031 Exchange is.
What is A 1031 Exchange?
The name “1031 Exchange” is derived from the section of the Internal Revenue Code which permits it. Specifically, section 1031 states that “…no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind…“
In other words, under a 1031 Exchange, IRS rules allow a property owner to sell an asset (the “relinquished property”) and defer the capital gains tax bill as long as they use the proceeds to purchase a new property (the “replacement property”) that is “like kind” to the old one.
Rules for 1031 Exchanges of Residential Property for Commercial Real Estate
When considering whether it is possible to exchange a residential property for commercial real estate, there are two key phrases in the IRS description that determine whether or not this is permissible:
- The residential property must be held for productive use in a trade or business or for investment (it can’t be held for personal use)
- The residential property must be like kind
Each of these requirements are discussed in detail below.
Held for Productive Use In a Trade Or Business Or For Investment
The language here is a little bit clunky, but it means that both the relinquished property and the replacement property must be held for investment. In other words, a property can’t be purchased just for the tax deferral and then quickly sold. In addition, the “held for investment” requirement means that a personal primary residence or vacation home cannot be used in a 1031 Exchange (NOTE: There are exceptions, but the process is incredibly complicated and expensive).
So, when attempting to complete a 1031 Exchange from a residential property to a commercial property, the first requirement is that the residential property must be “held for investment.” There is no specific language about how long a property must be held prior to sale, but 12-24 months is generally considered to be the minimum.
The Like Kind Property Rule
The words “like kind” are also a little bit nebulous, so the IRS has attempted to clarify them. On the IRS website, they state that “…both the relinquished property and the replacement property must be similar enough to qualify as ‘like kind,’ which is defined as property that is of the same nature, character, or class.“
So, what sorts of properties meet this test?
Properties that Qualify For a 1031 Exchange
To be considered like kind, the quality or the grade of each property does not matter. As such, most real estate is considered like kind to other real estate as long as both properties are located within the United States. So, for example, the following types of properties could qualify as like kind to each other:
- Apartment buildings
- Office buildings
- Retail properties
- Raw land / Vacant Land
- Warehouse / Industrial properties
- Residential investment property – like a single-family rental property – as long as it is held for investment purposes
Any of the above properties could be exchanged for each other as long as they are held for investment. It should also be noted that properties do not necessarily need to be exchanged on a 1:1 basis. They can be exchanged one for many as long as the following rules are met:
- Rule of Three: The exchanger can identify up to 3 like kind replacement properties.
- 200% Rule: The exchanger can identify unlimited properties as long as their cumulative value does not exceed 200% of the market value of the relinquished asset.
- 95% Rule: The exchanger can identify more than three properties whose value exceeds 200% so long as they acquire 95% of the value of the replacement properties.
For an investor who would like to exchange a residential investment property for a commercial one using a 1031 Exchange, the process is very straightforward.
Steps to Complete a Residential to Commercial 1031 Exchange
There are four types of 1031 Exchanges, but the one most commonly used is known as a “delayed exchange.” Using this type, a residential to commercial 1031 Exchange can be completed in three steps.
Step #1: Identify the Relinquished Property and List it for Sale
This step may seem obvious, but for investors that have multi-property portfolios, the first thing that they need to do is to decide which one they are going to sell. Once they have done so, they can choose a broker and list it for sale.
One the property is sold, a clock starts ticking on step #2.
Step #2: Identify a Replacement Property
How long do you have to do a 1031 exchange? Under IRS rules, a replacement property must be identified within 45 days of the sale of the relinquished property. This is easier said than done. Competition for the best replacement properties can be intense and it can be difficult to find one that is in the right price range with the right risk/return characteristics.
Once the replacement property has been identified and placed under contract, the transaction moves into step #3.
Step #3: Close the Deal
The tax code also states that the taxpayer must close on the purchase of the replacement property within 180 days of the sale of the relinquished property. So, once an investor has identified the replacement property, there is a lot of work to do in a short period of time. They must arrange financing, get title insurance, develop a management plan, transfer funds and execute the closing documents. Again, the relatively short time frame here can result in added stress for real estate investors so it is always best to be prepared and try to arrange as many things as possible ahead of time to avoid a time crunch.
It should be noted that a 1031 Exchange is a complicated and administratively intense transaction. For this reason, it is always advisable to use a qualified intermediary and/or a tax advisor to ensure all rules are adhered to. If they aren’t, the transaction could become taxable.
Is a 1031 Exchange With a Primary Residence Allowed?
Not in most cases. As discussed above, 1031 Exchange rules state that both the relinquished and replacement properties must be “held for investment.” So, a primary residence or vacation home does not meet this test and therefore cannot be used in a 1031 Exchange in most cases. This also holds true for other types of personal property.
Why It Makes Sense To Exchange a Residential Property for a Commercial One
For many investors, a residential investment property is an excellent way to get started in real estate investing. However, building an entire portfolio of residential investment properties can be difficult and time consuming. For this reason, there are several reasons it can make sense to exchange a residential property for a commercial real estate asset using a 1031 Exchange:
Scalability
In a commercial property, there are many leasable spaces located within the same building. For example, a multifamily property could have 20 units or a retail property could have 50,000 SF of leasable space. For this reason, commercial property can be easier to manage than residential properties, which may be widely dispersed over a particular geographic area.
Tenant Quality
In a residential investment property, the tenant is an individual or family and it can be difficult to get a lot of information about their financial condition (aside from a credit report and bank statement). On the other hand, commercial tenants have audited financial statements that can provide detailed insight into their ability to pay rent. This additional information makes it easier to select high quality tenants.
Long Term Leases
In a residential investment property, the typical lease term is 12 months. In a commercial property, the typical lease term is much longer. Three to five years is normal, but the lease could reach 25 or 30 years depending on the location and type of property. For example, an anchor tenant in a retail shopping center may see a location as strategically important. As such, they could be happy to sign a 25-year lease to ensure they will be there for a long time.
Fractional Ownership Interest
Finally, it is possible to obtain fractional ownership of institutional quality assets by using the proceeds of a residential sale to invest in a commercial REIT or private equity deal. This provides investors with all of the benefits of real estate ownership without the hassle of actually managing it. This sort of fractional ownership is not typically available with residential properties.
For investors who want to achieve these benefits, purchasing a commercial asset as a replacement property in a 1031 Exchange can be very beneficial.
So, Can You Do a 1031 Exchange From a Residential Property to a Commercial Property?
Yes, it is possible to complete a 1031/Like Kind Exchange with a residential property. However, the properties involved must pass two tests: (1) it must be held for investment; and (2) it must be “like kind.” For this reason, it is not possible to complete a 1031 Exchange with a primary residence.
If these criteria are met, the 1031 Exchange process can be completed in three steps: Sell the property, identify a suitable replacement, and close the deal.
It’s also important to note, investors can not complete a 1031 exchange into a REIT since they involve purchasing shares instead of real property.
Investors who make the residential to commercial real estate transition can benefit from investment scalability, higher quality tenants, long term leases, and fractional ownership of institutional quality assets.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
