1031 Exchanges and Rental Properties: Answers to Common Questions

Rental properties can be a great way to earn extra income while holding an asset that can go up in value, and with a 1031 exchange, you can build even more wealth.

For more than 100 years, IRC Section 1031 has allowed property owners to defer taxes on the sale of business and investment property through like-kind exchanges. While 1031 can be used for major endeavors like large commercial properties, farmland, and oil & gas leases, it can also be used by everyday investors who have purchased a second property as an investment.

There is plenty of misinformation out there about 1031 and how it can be used. You may even own a property eligible for 1031 without realizing it, or have misconceptions based on how 1031 is portrayed in the media. As an experienced Qualified Intermediary trusted by some of the largest names in the industry, we get plenty of questions about how 1031 works and who can use it. Here are just a few of the questions we often get about rental properties and like-kind exchanges.

How does a 1031 exchange work for a rental property?

If you own a second home or multifamily building that you rent out, this rental income is treated like any other business, which means the property could qualify under Section 1031, which applies to business and investment property.

Ordinarily, when you sell a property, you have to pay capital gains, depreciation recapture, and other taxes. This tax burden can significantly reduce the capital that you would then have left over to reinvest in another property, making it harder to upgrade to a more valuable property, which causes some property owners to hold rather than sell, even when opportunities are available.

Section 1031 eliminates this problem by allowing for tax deferral when the property is exchanged for a like-kind property. The word “exchange” doesn’t necessarily mean you trade one property for another (although it can). Instead, you can sell your current rental property (the “relinquished property”) and use the proceeds to acquire a “replacement property.” If you do this according to 1031 rules, your transaction will qualify as an exchange and the taxes will be deferred until you eventually sell in a taxable sale.

There are many kinds of exchanges, including forward and reverse exchanges, improvement exchanges, and others, but the most common is the forward or delayed exchange. In this scenario, your relinquished property is sold to a buyer and the sales proceeds are held by a third party known as the Qualified Intermediary (QI). From the date of sale, you have 45 days to identify potential replacement properties and 180 days to acquire one or more of them. The QI transfers the funds to the seller of the replacement property, you take title to the property, and your taxes are deferred. You can hold this new property until you sell it, either in a taxable sale or through another 1031 exchange. The taxes will only be due once you sell without performing another exchange.

What kinds of rental properties are eligible for 1031 exchanges?

A key component of IRC Section 1031 is that the properties being exchanged must be “held for productive use in a trade or business or for investment.” Any property where you perform business activity, such as a retail store, warehouse, office complex, factory, or plenty of other property types, will qualify. Renting a property to a tenant, whether it’s a single tenant in a single-family home or a number of tenants in an apartment complex, qualifies as business activity.

Your primary residence does not qualify under Section 1031. There is another part of the tax code, Section 121, which applies to a taxpayer’s main home. There are situations where a property is used as both a main home and for business purposes (such as a home office), and situations where both Section 1031 and Section 121 can apply. We’ll cover more of these situations later.

It’s important to note that Section 1031 does not apply to any property “held primarily for sale.” You must demonstrate that your intent was to purchase the property as part of a business venture, not merely to resell at a profit. There is also something called “dealer status” that applies to those whose primary trade is the buying and selling of real estate. Dealers and real estate developers can sometimes perform 1031 exchanges, but not always.

Rental properties are ideal for 1031 exchanges because rental agreements and the paper trail of rent collections provide ample proof that business was conducted. While large office complexes, shopping centers, and factories are frequently used in 1031 exchanges, this article’s primary focus will be single-family and multifamily rental properties that ordinary investors may hold.

If I sell a single-family home in a 1031 exchange, does it have to be exchanged for another single-family home?

A crucial component of Section 1031 is that the two properties must be “of like kind.” One of the most common mistakes property owners make is thinking that this means a property must be exchanged for another of the same type: single-family home for single-family home, multifamily for multifamily, retail for retail, etc.

In reality, the definition of like kind is treated loosely by the IRS. Any business or investment property can be exchanged for any other, so long as both were used in a productive trade or held as an investment. You can exchange a single-family rental property for a retail storefront, a shopping mall for a mine, or a multifamily building for shares in a DST (more on that later).

If you own a single-family rental property and want to perform an exchange, you aren’t limited solely to other single-family properties. Because of 1031’s flexibility, it’s good to explore all your options and find the right investment for your future.

I own a second home that I rent to a relative. Can I sell it in a 1031 exchange?

If you want to earn rental income from your property, and a relative or friend is looking to rent, it could make sense for you to rent to that person. It also might make sense for you to give your relative or friend a deal on rent because you’re so close. While it’s nice of you to do that, the IRS won’t be as charitable when evaluating whether or not your property was used in a productive trade.

As established in T.C. Memo. 2013–7, in order to qualify for a 1031 exchange, the tenant must pay rent at fair market value. If you let your aunt live in your vacation home and charge her only $1 a year, that won’t count. It’s possible to rent to a relative and perform a 1031 exchange, but not if you aren’t treating the rental as a legitimate business venture.

If you choose to rent to a friend or relative, be sure that 1) the rental agreement is in writing, 2) rent is set at a reasonable level for the area, and 3) you report all rent as income on your taxes. If the person renting from you is a relative, there will be extra scrutiny, so documentation is important.

If I own a rental property with another person, can I sell my share in a 1031 exchange?

If you own a multifamily apartment building or commercial real estate complex, you can be reasonably confident you qualify for 1031, as there will likely be extensive proof of business activity due to rental contracts and the collection of rent. These properties can be expensive to purchase and maintain, but there are options that make owning them easier.

Investors can pool their money to purchase a single property by forming a partnership or corporation. However, when you do so, you need to be aware of the same taxpayer rule, which states that the taxpayer on the title of the relinquished property must be the same as the taxpayer on the title of the replacement property.

This means that if you purchase a property as part of a partnership or LLC, then the replacement property in your 1031 exchange must also be owned by that partnership or LLC. You can’t perform separate exchanges without losing your tax deferral status. You and your partners must all agree on the decision to perform an exchange, or else it won’t qualify.

In some cases, it’s possible to dissolve a partnership before performing an exchange. The Drop & Swap method is where one member of a partnership or LLC exits and becomes a tenant-in-common (TIC) with the other owners. At this point, they can perform an exchange with their individual share. The rules for TIC and Drop & Swap exchanges vary by state, and can result in extra scrutiny from the state’s tax board, so understanding the rules in advance and working with the right professionals is crucial.

Delaware Statutory Trusts (DSTs) pool the funds of many investors to purchase a suite of properties. Each investor can do an exchange into or out of the DST for their individual interest. There are pros and cons to DST ownership, but for some property owners, it can be a great backup option when identifying potential replacement properties.

It’s also possible to perform a 1031 exchange into a triple-net lease (NNN) property that has lower maintenance and longer tenant leases, eliminating a lot of the work of managing rental properties and providing less risk. There are a lot of options, so just because you can’t afford a large rental property on your own doesn’t mean you won’t be able to perform a 1031 exchange.

My single-family rental home has a mortgage. Can I perform a 1031 exchange if there is still debt on the property?

Single-family rental properties have some advantages over larger ones purchased with other investors. If only your name is on the title, you don’t have to worry about what your partners will want to do. That’s why many exchangers are not corporations investing in hundreds of properties, but everyday investors who own a second home that they rent out for the additional income.

Mortgaged property is fine under Section 1031 but complicates the math of your exchange. When you perform a 1031 exchange, if your replacement property is valued higher than your relinquished property, you can defer all of your capital gains from the relinquished property sale. But if the replacement property is worth less, you’ll receive some cash at the end, known as a boot, and this will be taxed.

The same is true for debt. If you want to achieve full tax deferral, then your replacement property must be purchased with the same amount of debt (or more) than your relinquished property. Depending on how interest rates have changed from the time you purchased your relinquished property to when you’re acquiring your replacement property, you may not be able to achieve the same loan terms and could end up paying more in interest.

If I move out of my home and rent it for a while, can I perform a 1031 exchange?

It is possible to transition a property from your main home to a business property. If you live elsewhere and rent the property for a period of time, you can establish business use and then perform a 1031 exchange with your former primary residence as the relinquished property.

The tricky part is knowing how long to rent the property. The rules for this scenario are not cut and dry, so you need to be careful. Many professionals recommend renting the property for at least two years, but there are always exceptions. In general, the longer you can rent the property out, the better off you’ll be.

I own a duplex and live in one unit while renting out the other. Is my property eligible for a 1031 exchange?

Section 1031 (for business or investment properties) and Section 121 (for primary residences) can apply to the same property. For example, if you operate a retail store or restaurant on the first floor of a building and live on the second floor, Section 121 would apply to the portion of the building you live in, while Section 1031 would apply to the portion used for business.

The same is true of a duplex or multifamily building where the owner lives in one unit while renting out the other(s). You can use the Section 1021 exclusion on the portion of the property used as your main home, while performing a 1031 exchange for the portion of the property used for business. In this case, you’d need to accurately calculate the portion of the property used for each, which is why experienced accounting and legal professionals are essential for a successful exchange.

You could also move out of the unit in which you reside and rent it for a period of time as in the previous example. That way, you could exchange the entire property and potentially upgrade to a more valuable replacement property.

I have a vacation home that I occasionally rent out to others. Is my vacation property eligible under Section 1031?

Your rental property does not have to have a tenant year-round in order to qualify. Short-term vacation rentals can be empty for part of the year without running afoul of the rules. This is useful for those who own a vacation home they wish to use themselves part of the time and rent out the rest of the year. As with the question of renting to a friend or relative, you must charge a reasonable rate to establish business use.

The minimum number of days the property must be rented per year is 14. That’s not a lot, but you’ll also only be able to use it for 14 days yourself. If you’d like to employ the property for personal use more than that, you’ll need to rent it out longer, so your use doesn’t exceed 10% of the days rented.

For more information, read our guide to 1031 and vacation properties.

Can I do a 1031 exchange and then use the new property as my primary residence?

Just as it’s possible to transition from a 121-eligible primary residence to a 1031-eligible business property, it’s also possible to perform a 1031 exchange and then eventually make the replacement property your main home. Many retirees pursue this path, choosing to downsize once their kids move out or live full-time in a former vacation property in a warm-weather state.

While making a 1031 exchange property your primary residence is possible, it’s important to understand the rules because a 1031 exchange can be deemed invalid after the fact. You need to wait a period of time before moving into the property so it’s clear your initial purchase was for investment purposes. And if you eventually wish to sell this new home under Section 121, you’ll have to wait five years before you’ll be eligible for the exclusion.

For more information, read our guide to 1031 & 121.

Should I sell my rental property in a 1031 exchange?

The decision of whether to perform a like-kind exchange is unique to the individual, and may hinge largely on the reason you’re looking to sell: is it because you’ve found a new property that you think could earn you more income, or because you don’t like managing property and want to try something else? Is it because the property hasn’t grown in value the way you wanted, or because you want to move to a new area? Is it because you’re hoping to diversify, or because you want to use the income for retirement?

Your answers to these questions will help you determine whether or not you want to invest in a new business property. If you do, it’s important to know your options. As we’ve shown, there are a lot of options when it comes to tax deferral, and major benefits if you continue a 1031 strategy as long as you can.

For example, if you haven’t held the property very long, you might not qualify for the long-term capital gains rate. Performing a 1031 exchange will ensure you can defer those taxes to a later date when you will qualify. There’s also the potential to hold investment property until your death so your heirs can receive the step up in basis.

A major reason to pursue an exchange right now might be tax related. Currently, Section 1031 appears safe from any changes in the tax code, but in the past, there have been proposals to eliminate 1031 or place a cap on how much can be deferred. Taking advantage now would be the right move if you think this option won’t be there in the future. (Although it is important to point out that many industry professionals believe Section 1031 is in a strong position and not facing any near-term threats).

The decision of whether to sell your property is up to you, as is the decision to defer taxes through a like-kind exchange. If you decide to pursue an exchange, it’s important to get good advice from legal and accounting professionals and engage a QI early in the process. You can’t control whether 1031 exchanges will exist in 30 years, but you can take steps to ensure you’ve set yourself up for a successful exchange.

How do I perform a 1031 exchange with a rental property?

Rental properties can be a great source of income, and deferring taxes with a 1031 exchange can help you upgrade to more valuable properties and earn even more through rentals. Depending on your future plans, you’ll need to take specific steps to make sure you qualify and don’t leave money on the table.

The most important thing you’ll need is a Qualified Intermediary (QI). If you take actual or constructive receipt of the sales proceeds from your relinquished property at any time, your exchange will fail and you’ll owe taxes on the property sale. A QI holds those sales proceeds during the exchange and ensures that funds are kept secure during that time.

Finding a QI with whom to trust your financial future isn’t a decision to be taken lightly. That’s why JTC holds all exchange funds in qualified escrow or qualified trust accounts and never releases funds without dual authorization from both the exchanger and JTC. We also offer our clients access to our 24/7 online portal so you can view exchange information at any time, from anywhere in the world.

With an experienced team that has specific expertise in complex exchange types, JTC can facilitate exchanges other QIs can’t. When you’re ready to perform an exchange with your investment property, get in touch with a JTC representative to learn how we can help you achieve your investing goals.