Does property qualify for 1031 Exchange ?

Question

Hi, Own multiple California properties in two different beach resort areas. In 1999 built a home on one of the properties. It was not a vacation home, but was held for investment and depreciated it on day one. I also did not rent it out. My accountant said I was not required to rent it. In the last two years rented briefly to friends. Would like to do a 1031 exchange with another property I own, but is unimproved at the moment.  Does the existing house qualify for the exchange? Thanks, Don

Don Darnell · Answer

Thanks Dave for the useful information. As I mentioned, I had heard of the construction 1031, but not the leasehold exchange. I have owned the lot for many years and see it as a perfect retirement spot. I'll spend some time looking into the leasehold exchange idea. Thanks again - Don.

Dave Foster · Answer

@Don Darnell sorry for your loss.  It's tough losing team members.  A construction exchange is similar to what I was referring to.  In a construction exchange the QI takes title to a new lot and then the structure is built before passing over to the exchangor to complete their exchange.

While similar, a leasehold exchange is different in that you can build the structure on land you already own using a long term land lease.  Similar to what we see in commercial syndicated ground lease opportunities or certain residential areas where houses are built not on fee simple ground but on long term land leases.   A capital land lease of more than 30 years duration has been construed to be an equivalent bundle of rights to ownership of fee simple real estate.

You would lease your lot to the QI on a long term lease and then the QI would complete construction of a structure.  At which time you perform your exchange and use the sales proceeds to "buy" the long term lease and improvements that have been made.

It is complicated and there is very little guidance from the service on this one.  A favorable private letter ruling was issued a few years ago but there has been litle  structural guidance on process.  But if you're comfortable in the 1031 world and have a good team around you and most importantly, if you really really like the lots you have, it might be something to look at.

Don Darnell · Answer

Thanks Dave for your response. I posted the question because 1) My accountant has passed away and he was really into 1031 exchanges. 2) I was finding articles on the web talking about a minimum 14 day rental period requirement for certain properties and was confused if my property needed the requirment.

I understand I cannot exchange the house for the lot, but I've send articles referencing a Construction 1031 where the proceeds of the old property are held in a LLC managed by a QI. The QI oversees the construction and within 180 days I acquire the constructed property. Is this what you mean by "leasehold" ?

Thanks again,

Don

Dave Foster · Answer

@Don Darnell,Your accountant is correct.  There is no statutory holding or income requirement for a property to be eligible for  a 1031 exchange.  The standard is that you have held the property for productive use in business, trade, or for investment.  There are numerous types and uses of property that qualify and it is up to you and your accountant to be comfortable with your treatment and intent for qualification of the property.  So if he's comfortable with it then go for  it.

The problem you've got is in what you want to do with the exchange.  You must sell (relinquish) your old property and then purchase new (replacement) property.  You cannot exchange for property you already own.  Any kind of investment property may be exchanged for any other type so the issue is not the type but only the fact that you already own the one you want to exchange in to.  So plan A is out.

Depending on what you want to accomplish though there are some other options.

1. Combine two exchanges, the house and the vacant lot and use the proceeds to buy a completed house on a similar lot (or any other property you would choose).

2. Sell the house and 1031 into something totally different.

3. Consider an exotic product like a "leasehold" exchange which would allow you to exchange into improvements on the lot you own.  This is a very complicated process that takes some delicate guidance and is not for the inexperienced investor.  But your accountant sounds like a very savvy person and with their guidance and an experienced QI you could consider something like this.