From One Mixed-Use Property into Multiple Short-Term Rentals, using Section 1031

One of the benefits of the like-kind requirement as it relates to real estate is that all real estate is like-kind to other real estate. What does this mean? If you own a mixed-use property, you are not required to buy another mixed-use property when choosing 1031 exchange. You can convert it into an asset that better aligns with your long term investment goals, such as purchasing with properties intended for short-term rentals.
home with white fencing around it and a red sign that says "for lease" example of property eligible for 1031 exchange

Many investors are aware of the value of Section 1031 exchanges in their real estate portfolios. These investors use 1031 exchange to reposition their investments to other neighborhoods or other states, or to reallocate their investments to different asset classes.

The Situation

Andrea currently owns a mixed-use building with 5 residential units above a retail storefront. The property also has ample off-street parking on a 1½ acre lot and is situated near a busy commuter road. Nonetheless, her income from the property is limited due to the market rate for this type of property in her community. Andrea acquired the property about ten years ago for $500,000. A developer is interested in the converting the property into a convenience store and gas station, and has offered Andrea $700,000, which she is considering accepting.

The Problem

Andrea has grown disillusioned with the property because her state imposes stricter regulations on properties with five units or more, as well as the limited cash flow potential. She had been considering selling the property anyway, but her accountant has just told her that she will have a sizeable tax bill if she sells outright. In round numbers, Andrea can expect to pay taxes as follows:

The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation recapture tax($128,000 x 25%)$32,000
Capital gains tax($200,000 x 20%)$40,000
Estimated state capital gains tax $26,240
Affordable Care Act tax($328,000 x 3.8%)$12,464
Total estimated tax owed $110,704



Selling the property outright would net Andrea approximately $589,000 after the taxes. While Andrea wants to get away from the burdensome restrictions imposed on her by the state, and the developer’s offer is tempting, the prospect of losing nearly 16% of the sale price to taxes is less palatable than dealing with the state rules and regulations and limited cash flow.

The Solution: A 1031 Exchange into Multiple Short-term Rental Properties

Andrea will structure the sale of the building as part of a Section 1031 Like-Kind The transfer of the relinquished property to the Qualified Intermediary, and the receipt of the replacement property from the Qualified Intermediary is considered an exchange. To be compliant with IRC Section 1031, the transaction must be properly structured, rather than being a sale to one party followed by a purchase from another party. Exchange . After consulting with her attorney and a Qualified Intermediary (“QI”) like Accruit, Andrea now understands that “like-kind” does not require her to replace the old property with a multi-family or mixed-use property.

Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Andrea’s QI to be held on her behalf until the purchase of her replacement property. This is necessary because a person doing an exchange cannot come in actual or constructive receipt of the net sale proceeds while the exchange is pending.

Within 45 days after the closing on the sale, Andrea properly identified five furnished rental condos for approximately $150,000, for a total investment of $750,000. (Learn more about Identification rules in 1031 exchanges.) Closings on the various condos occurred over the next several months, well within 180 days of the sale of the relinquished property, utilizing the exchange proceeds held by the QI. After closing, each of the properties will be listed as short-term rentals on Airbnb, VRBO, or similar services. Andrea has now shifted her equity to multiple properties with significantly higher cash flow potential, without recognizing the gains.

Technically speaking, the furniture in the condos could be considered “boot” as it is not real estate. However, the furniture is used, and has been assigned a value of less than $10,000 in each of the units, for an aggregate value of less than $50,000. Since she will be selling the old property for $700,000, and the value of the new properties is $700,000, she will not be facing any taxable boot issues. Andrea will now be free of the more stringent rules imposed on properties greater than four units, and has prospects of better cash flow as well. Andrea structured the sale of the old property as part of a Section 1031 tax-deferred exchange, and has exchanged into replacement properties of equal value, to fully benefit from Section 1031.

The Result

Andrea has successfully completed a 1031 exchange from one mixed-use multi-family relinquished property into multiple replacement properties. She exchanged equal or up in value, using all of her equity, fully deferring the anticipated capital gains and depreciation recapture taxes. Andrea has now escaped the onerous burdens imposed by her state on owners of properties with more than four units, and is anticipating better cash flow as well.

Review the basics of Forward Exchange, which you may review with your tax and legal advisors.

Start an Exchange