To Exchange or Not to Exchange

I was recently contacted by a client asking if they could exchange the proceeds from the sale of a commercial property they had inherited a partial interest in for a home elsewhere in the state.

I let them know that to my understanding there is no requirement to exchange into another commercial property to qualify as like kind under the IRC Sec. 1031 Exchange rules, and in fact, many of our clients roll exchange proceeds from their commercial income properties into a home or multiple homes that they buy and use temporarily as a rental for 1-2 years before changing the use to a personal residence, which takes them off the capital gains merry-go-round once the use is changed.

To do this, you need to be careful that your ownership interest in the home is clearly held as a non-resident Tenant in Common on the replacement property where you would receive rents for a period of time deemed acceptable by your CPA before converting your interest in the home to owner-occupied.

You also need to be sure language is included in the contract for the sale of the property being relinquished allowing the individual sellers to opt for exchanging their portion of the proceeds individually as they please since in order to set up a 1031 exchange the contract needs to include a statement of intention, and if it doesn’t then a Seller’s Intent to Exchange Addendum can be circulated for all parties to sign on the way to appointing an exchange intermediary.

As well, any portion of proceeds being held back from the sale cannot be used towards the replacement property since they wouldn’t meet the strict timeline requirements of an exchange, but so long as your CPA and exchange intermediary give their blessing to the arrangement you can use a portion of your proceeds and pay capital gains on the remaining funds when you receive them. 

For the client in question, after reviewing the deal structure for their sale it turned out that the majority of proceeds were being held back after Close of Escrow, so only a small amount of funds would have been available to exchange into a replacement. 

The only work-around in such a situation might have been to substitute the potential trade proceeds with other funds… but this could only be done if they had seasoned cash available, and if an arrangement is even possible to swap out proceeds like that, it needs to be orchestrated by your CPA and tax attorney.  Sound convoluted? It is, but these are the types of scenarios that get explored along the way to come up with the best path forward.

In the end, it was also determined that since the property had sold for a price similar to the step-up in basis it had received at time of death, there would likely have been minimal to no capital gains consequence to protect in the first place, so the decision was made not to exchange, but rather simply take the limited funds at closing and wait until the balance comes in later to buy a replacement home.