With only 45 days from the sale of a property to identify a like-kind investment, choosing a replacement property in a 1031 exchange has the potential to be a high-pressure decision.

It doesn’t have to be.

Investors have an array of options, and if they have a plan before relinquishing the original property, it’s likely they’ll end up with a replacement property that matches their objectives.

What is a like-kind investment?

A 1031 exchange requires the proceeds from the sale of real estate investment be reinvested in a like-kind investment of equal or greater value. In return, capital gains and depreciation taxes are deferred.

It’s important to note that “like kind” doesn’t mean exactly alike. Rather the statute sets guidelines as to the type of property that can be included in an exchange rather than specify the properties be similar. For example, a single-family home does not need to be exchanged for a single-family home. A commercial building does not need to be exchanged for another commercial building.

The statute provides a broad interpretation of a like-kind property and the description of the relinquished property does not affect the replacement property possibilities. The new property can be a single-family home, a commercial building, an apartment complex, or even vacant land. In the case of a Delaware Statutory Trust (DST), it might not be a property at all, but rather shares in a trust that then purchases properties on behalf of its investors.

What doesn’t qualify as a like-kind investment?

Most real estate qualifies as a like-kind investment as long as the property is located in the United States and it’s intended to be a long-term investment. 

Personal property such as a vehicle or collectibles, along with stocks, bonds, and other securities cannot be included in a 1031 exchange. The same goes for a vacation home or primary residence.

A Qualified Intermediary (QI) must be used to facilitate the exchange, and an experienced QI can assist if there are questions or gray areas.

Investors aren’t confined to a single property

The definition of a 1031 exchange implies an investor is exchanging one property for another property, but the rules stipulate that multiple properties can be exchanged for a single property or the proceeds from a single relinquished property can be reinvested in multiple properties.

Investors have 45 days from the sale of the original property to identify up to three replacement properties and have 180 days to close on at least one of the options. It’s also possible to identify more than three replacement properties as long as the value of those properties doesn’t exceed 200% of the sale price of the original property. It’s possible to identify an unlimited number of replacement properties as long as the investor closes on at least 95% of the value of those properties.

Why consider a DST?

A DST is a long-term investment in which shares, rather than a physical property, are purchased. Investors benefit from having professional management of the investment and daily oversight of the properties. The investor no longer has to worry about middle-of-the-night calls when a pipe breaks or finding new tenants.

DSTs are long-term, illiquid investments meant to last five-to-10 years. If shares need to be sold before the DST ends, shares would need to be sold either to another original investor or on a secondary market, and those options are not always readily available.

What happens when cash out is needed?

The replacement property in a 1031 exchange must be of equal or greater value of the relinquished property. However, if an investor needs a portion of the proceeds from the original property, it’s possible to take money out, pay taxes on that amount, and reinvest the rest in a partial 1031 exchange.

Identifying a replacement property, or properties, as part of a 1031 exchange can be a difficult decision that takes planning and knowledge of the qualifying factors.

Contact us if you have questions. We always recommend speaking to a financial professional or tax advisor about your individual circumstances.