Condo development and 1031 exchange

10 Replies

I have bought and am renovating a 3 unit building.  I'm now going over my options to get my money out of this building.  My choice are rent and hold, sell a single unit, or convert the units to condos and sell them individually. 

My question revolves around the last option, converting to condos.  If I do this, they'll sell in three individual units.  How would this work with a 1031 exchange.  Is a 1031 exchange possible in this scenario?  If so, would it be three separate exchanges?  Would it, or could it, be a single multitransactional exchange (if that is even possible)?

Going further if it's three exchanges, could those be combined into one single purchase transaction on the back end.  By this I mean that I sell the individual condos for $300K each, but then buy a single $1 million property, using that to close out all three of the individual condo exchanges.

Does anyone have any idea if any of this is viable?

A condo conversion is an activity, not a long term investment, and not eligible for a 1031, even if it takes more than a year to complete.

If a condo conversion is a legal proceeding only there is some precedence for it not being an activity of resale.  Just like there is precedent for entitling raw land but not turning a shovel on it and still be eligible for 1031 treatment especially if you feel you can demonstrate that your intent was not primarily resale and some time has passed.  We have legal experts and clients falling on both sides of the fence on this.  

However, there is also another alternative that you're not seeing yet that may be the best of all.  As ownership rates continue to rise there could be some very good value in doing a conversion.  However if your intent in doing it is simply to resell then you would not be able to 1031.  But what if you converted and then rented the units maybe even on a lease/option properly structured?  Now you have rental assets that you could 1031.  Or you could still sell all three as a package to one individual who would then have all the benefits of both a triplex and 3 sf homes.  I don't know about everyone else but as a landlord/investor that would have huge value to me.

Each sale is a separate 1031.  However, if you are selling all three to one individual at one time it is possible to treat that as one exchange if you so desire.  You may also treat it as three separate exchanges and use the proceeds to purchase one larger asset as long as you conform to the timelines of the 1031s.

I see what you're saying.  If I rent them, then sell them, it's 1031-able.  If I just renovate and sell, it isn't?  Does it matter if I sell the building as a single unit or three units?

At that point it wouldn't matter a bit.  What you have are three rental investment properties.  You could sell them all to one buyer at one time and do one 1031 or to three buyers at three different times and do 3 different 1031s or any combination thereof.  With the heat of the MF market nationally coupled with the upcoming SF purchasing trend you're in a good spot right now.

Originally posted by @Michael Wolffs :

I see what you're saying.  If I rent them, then sell them, it's 1031-able.  If I just renovate and sell, it isn't?  Does it matter if I sell the building as a single unit or three units?

Hi Michael,

The key element that was not stressed enough here is your intent.  You would have to be able to demonstrate your intent to hold for rental or investment purposes (and not for resale purposes) should you get audited.  There are also cases where the holding period has been years, but the 1031 Exchanges were disqualified because the taxpayer's true intent was to hold for sale and not for rental/investment.  So, it all boils down to your intent and whether you can demonstrate this if you should be audited.

@Bill Exeter

@Dave Foster

I have a similar situation to Michaels. I bought a fourplex using a 1031 exchange and am now in the process of condo converting to 4 condos. Since the area is only getting better, I do intend to hold the units and rent them out.

Judging from the answers above, I would assume I would have to do a 1031 exchange for each condo unit, should I sell them down the line. My question is what happens to the rule that the new property must be higher in value than the relinquished property? Would that value just be divided by 4? I'm assuming the deferred taxes from the previous property would also be divided by 4 and be deferred again at the sale of a condo unit. Kind of tricky, thanks for your input!

@Aaron Smith , the conversion actually creates 4 individual pieces of real estate. You're correct that you may have 4 different exchanges unless you sell more than one to one buyer as one contract.

It is the sales price of the asset that determines your reinvestment criteria.  The basis of the original property is divided appropriately and depreciation is allocated prorata so that your adjusted cost basis is accurate and you then have only the allocated gain from that one unit to content with.  In a simplistic example a 400K property broken down into 4 equal units would yield a basis for each one of $100K.  If you sold one for $200K you would have a profit of $100K and a reinvestment target of $200K to defer all tax in a 1031.

Just one more of the calcs needed by your conversion team to complete the conversion.

Hi @Aaron Smith

Yes, when you sell one of the condos in the future the sale price at that time is what determine your reinvestment requirement.  You would have to acquire one or more replacement properties that are equal or greater in value than the sale price of the condo that you just sold.  

Make sure that you document your intent to convert and hold as rental properties just in case you have to sell them sooner that you expected.  It all boils down to whether you can demonstrate intent to hold for rental or investment vs. intent to convert and sell. 

@Bill Exeter , @Dave Foster

That's what I figured. As always, thanks for the great information and advice. I will certainly document my intention to hold as well.

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