One of the key requirements of a 1031 Exchange is that both the property being sold, the relinquished property, and the new property being purchased, the replacement property, have to have the same title and they have to be held for investment purposes. Many real estate investors find no issue with this rule, but if they change their mind after an exchange is complete and want to change the ownership of a property following an exchange, it could be problematic.
In this article, we describe what a 1031 Exchange is, the basic requirements for completing one, and what happens if property ownership needs to change after it is completed. By the end, readers will have a greater understanding of how a 1031 Exchange works and what happens if/when ownership needs to change.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers and often assist investors with the placement of their 1031 Exchange funds. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is a 1031 Exchange?
To understand the impact of ownership changes, a little bit of background on 1031 Exchanges and the associated tax code is required.
If an individual sells an investment property for a “gain,” they are required to pay capital gains taxes of up to 25% depending on how long the property was held and the income tax bracket of the taxpayer. But, IRS rules provide taxpayers with a way to defer the tax bill if they reinvest the sales proceeds into another like-kind property. This type of transaction is known as a 1031 Exchange, sometimes referred to as a like-kind exchange or tax-deferred exchange.
1031 Exchange Rules
While the process may sound straightforward, the IRS defines a number of rules in the Internal Revenue Code (section 1031) real estate investors must follow when completing a 1031 Exchange. The most important of them include:
- Property Type: Both the sold property and the new property must be “like kind” to each other. In general most commercial properties are like kind to other commercial properties. But a commercial property is not like kind to a primary residence or vacation home. IRS rules specifically state that the property must be held for “productive use in a trade or for business or for investment.”
- Time Period: Investors have 45 days from the sale date of the “relinquished property” to formally identify a “replacement property” and they have 180 days to close on the purchase of it.
- Reinvestment Amount: Investors must reinvest all of the sale proceeds and gain into the new property and it must have a market value equal to or greater than the old property. If the investor receives any cash or personal property in the exchange, it is considered to be “boot” and it is taxable.
- Title: Finally, both the relinquished property and the replacement property must have the same title. So, for example, if an LLC is the owner of the old property, the same LLC must be the owner of the new property.
With regard to the question posed by this article, both the last requirement and the rule that the property must be “held for business or for investment” are key.
Can An Investor Change Ownership of a Property After a 1031 Exchange? Factors to Consider
With the background established, the short answer to whether an investor can change ownership of a property after a 1031 exchange is … maybe. There are a number of factors that must be considered to provide a more definitive answer one way or the other.
Remember, the property must be held for “productive use in a business or for trade or for investment” and both the old property and the new property must have the same title. If a property were to change ownership shortly before or after a 1031 Exchange, there would be a strong case this test was not met.
Exchange rules do not explicitly state how long a property must be held after the exchange, but the general consensus is it should be held for a minimum of 1-2 years. Anything less than that could disqualify the exchange and cause it to become taxable.
2. Structure and Ownership
Most commercial properties are purchased in a single purpose entity known as a limited liability company or LLC for short. It would not be allowable to change ownership from one LLC to another after a 1031 Exchange since this would violate the title requirement.
It may be allowable to convert the ownership structure of an exchange property from an LLC to a tenant-in-common structure – which allows individuals to own a fractional share of the property directly (as opposed to shares in an LLC that owns the company).
But, it is not recommended that an LLC to Tenants in Common conversion take place in close proximity to the completion of a 1031 Exchange. Again, a minimum recommended holding period is 1-2 years before the ownership structure is changed.
Post-exchange, the property can be placed into a revocable living trust, Delaware Statutory Trusts, or Tenants in Common structure and still achieve full tax deferral. These entity types are considered to be “disregarded entities” and a title change into one of them will generally be within the bounds of 1031 Exchange rules.
Again, the timing issue must be considered here. The ownership transfer should not take place immediately after the completion of a 1031 Exchange. Investors should wait 1-2 years before considering it.
If any of the 1031 Exchange rules are violated in the completion of the exchange, there could be tax consequences. If the exchange is disallowed by the IRS, the full amount of the gain could become taxable.
Why Consulting With Experts Is Important
Trying to change the ownership structure of a property recently involved in a 1031 Exchange is a complicated task and probably too much for an individual investor to manage on their own. Thus, it is a best practice to work with a number of experts to help keep the transaction within the bounds of the rules. These experts include a Qualified Intermediary, CPAs, and tax advisors, each of whom have a specific area of expertise regarding 1031 Exchanges. Together, they can guide their client(s) to a successful outcome.
What is a 721 Exchange?
If a real estate investor is looking to defer capital gains taxes, but is not sure they want to exchange into another property, an alternative option is to use a 721 Exchange.
A 721 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they exchange their property for shares in a REIT.
A 721 Exchange technically qualifies as a change of ownership because, once the exchange is complete, the REIT is the new owner of the property.
Investing in a Real Estate Syndication
For investors interested in a 1031 Exchange, one of the biggest challenges is finding a suitable replacement property in a timely manner. To alleviate this challenge, one option that investors can consider is to invest their exchange proceeds into a real estate syndication.
In this scenario, an investor would sell the relinquished property and then use the proceeds to purchase a fractional share of a larger property through the aforementioned tenants in common ownership structure.
In many cases, the syndication is led by a private equity commercial real estate investment firm, like us, who handles all of the logistics of the transaction from acquisition to property management. For investors looking for a hands-off ownership experience, this may be a compelling option.
A 1031 Exchange is a type of commercial real estate transaction that allows individual investors to defer taxes on the profitable sale of an investment property as long as they reinvest the sale proceeds into another “like kind” property.
There are many requirements for successful completion of a 1031 Exchange, outlined in IRC section 1031, investors must follow to achieve full tax deferral. Among the most important are the property must be held for “productive use in a trade or for business or investment.”
If an investor determines they want to change ownership of a property shortly before or after a 1031 Exchange, it is possible the IRS may view this as not a true investment, but a transaction designed to avoid tax liability.
Although it is not explicitly stated, it is generally agreed owners should hold a property for at least 1-2 years post exchange before considering an ownership change.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.