Can my parents do a 1031 exchange for an addition to their home?

by G. Scott Haislet, CPA, Esq.

My parents plan to sell a commercial building they’ve owned for 35 years. They want to use the money realized on the sale to pay for an addition to their home. They plan to continue their business out of the addition. Can they use a 1031 exchange?

Section 1031(a)(1) provides that gain is not recognized on (1) exchange of property; (2) properties exchanged are like kind; and (3) relinquished property and replacement property are both held for "business" or "investment."

Conceptually, the addition to the home could be like kind business replacement property for the relinquished commercial property under the general rule under section 1031(a)(1), provided both the commercial building and the addition are considered real estate.

Unfortunately, absent special handling, the receipt of the addition would not be considered real estate received. Instead, technically, the receipt of the addition would be considered business personal property (i.e., receipt of building materials and labor), thus not like kind to the commercial building. The "receipt" of the addition is manifested by the contractors supplying labor and materials to build the property. Thus, while the final product is real estate as an addition to the existing building, the law views it as receipt of delivery of goods and services (which are not real estate). Obviously, this is a very subtle but important nuance.

The special handling required to make this transaction qualify as a 1031 exchange (i.e., to avoid receipt of goods and services) constitutes a transaction involving material tax risk. This should not be attempted without counsel from a CPA or tax attorney with specific expertise in complicated 1031 transactions. You can find out more about like-kind exchanges by listening to CalCPA’s Financial Empowerment podcast on the subject.

G. Scott Haislet, CPA, Esq., is a tax adviser, estate planner and real estate attorney.

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