Can I Do This?

Question

I am new here, a friend suggested I join this forum, I’m glad I found it, I’m sure I’ll be here often. I have a 1031 exchange question, can I do this?  I own two adjacent properties, one is a 1031 exchange property (I’ve owned/rented it for two and a half years) the other is not 1031 exchange property.

I have determined the most profitable plan is to redevelop these properties into two condos, removing the existing structures, combine the property into one property, building two new spec condos.(Combining is required to build two condos, two houses are not allowed due to lot size and one house is not economically feasible).

The costs will be separated, using actual construction cost for each condo. The condos will be two separate structures (not attached) and have different number and street addresses.

My plan is to acquire a new 1031 exchange rental property with the sale proceeds of my current 1031 property in a proper 1031 exchange procedure. Will this transaction jeopardize my current 1031 exchange status?

John Peters · Answer

Thanks, I will discuss with my CPA.

Dave Foster · Answer

@John Peters, Yes, renting the properties for a period of time after construction would make a huge difference and again change your intent - this time back to holding for productive use.  So the 1031 would be appropriate.

There are points along the way that demonstrate what your intent was/is with your property.  When you bought the properties you held them for investment (productive use).  So your intent was consistent with the use that is required by a 1031.  However, if you build (turn a shovel, not just get entitlements or a rezoning) then you are creating a different piece of real estate.  If you immediately sell that then you are demonstrating that your intent with this new piece of real estate is to use it as inventory - not eligible for 1031.  However, if you build those condos and then rent them out you are demonstrating that your intent is to hold them for productive use so the 1031 is back on the table.

The easiest thing to do might be to lease them with options to purchase.  That way you could get the benefit of motivated tenants or a master landlord and cash flow while still preparing for an eventual 1031 by making sure your intent would be perceived as holding rather than immediate resale.

A conversation with your CPA about alternate construction entities should prove helpful as well.

John Peters · Answer

Sorry, first time replying, I posted my reply to you under a different response, so I will re-post it.

Thank you for your comment, I respect your opinion.  I will discuss with my CPA how best to structure the entities.  Also, under consideration is renting it for some time before selling, do you think this would help?

John Peters · Answer

Thank you for your comments, I respect your opinion.  I will discuss with my CPA next week how to best structure the entities. Also, under consideration is renting it for some time before selling do you think this might help?

John Peters · Answer

Thank you for your comments, I appreciate your opinion. I will discuss with my CPA next week, how best to structure the entities.  Also, under consideration is renting it for some time before selling, which may help.

John Peters · Answer

Thank you for your comment, these condos are not attached and are built for owner occupancy not rental property purposes.

Jim Carney · Answer

Why aren't you selling both properties to one buyer?

Dave Foster · Answer

@John Peters, There are a couple of ways to skin the cat but as you describe but it is also very possible that the transaction could actually destroy both your 1031 advantage and tax advantaged status on the other property unless that happens to be your primary residence right now.  When you begin building your condo on that lot you have changed the nature of the real estate and the nature of your intent.  You are creating inventory with the intent to resell.  That could cause a reclassification of that property into inventory and you could be subject to ordinary income tax including self employment and the full depreciation recapture you've carried forward.

While you're in the planning stages there are some things you can do with entity structure that could still leave the 1031 available to you.  Much depends on your personal situation, goals and abilities.