Can You Exchange the Converted?

A NonReligious Look at 1031 Exchanges and Apartment-Condo Conversions...

Apartment-condominium conversions have become a very lucrative way to make money in real estate these days. They are very popular in resort areas as people see that individual condominiums are worth more as separate units as compared to a single apartment building for rent. In addition, investors and developers are converting office buildings for rent into office condominiums for similar reasons. However, a question we are frequently asked by our clients is whether such a conversion will qualify for a 1031 exchange. The short answer is "maybe," as long as they are structured properly

Apartment-condominium conversions have become a very lucrative way to make money in real estate these days. They are very popular in resort areas as people see that individual condominiums are worth more as separate units as compared to a single apartment building for rent. In addition, investors and developers are converting office buildings for rent into office condominiums for similar reasons. However, a question we are frequently asked by our clients is whether such a conversion will qualify for a 1031 exchange. The short answer is "maybe," as long as they are structured properly.

...In essence, that's what it is -- the division of space from a single piece into separate pieces of real estate...

In such a transaction, an investor will purchase an apartment building. Next, the investor gets approvals to sell individual condo units from the municipality in which the project is located. Also, the investor will typically make certain improvements and upgrades to the units, such as separate utility meters. Finally, the investor/developer will sell the individual units -- the hope being that large gains will be earned on those sales. But, can the investor defer his or her gains by performing a 1031 exchange?

In the 1031 context, the problems with apartment-condo conversions are the same as they are for subdivisions of land by developers. And, in essence, that is what an apartment-condo conversion is -- a subdivision of air-space from a single piece of real estate into separate pieces of real estate, or condominiums.

Congress and the IRS wish to exclude developers and dealers of real estate from performing 1031 exchanges. In their opinion, these people should pay taxes as ordinary income on their gains, since development is their main livelihood. However, regular investors can be classified as developers if they begin to act like developers. For instance, subdividing your land, installing infrastructure and selling individual lots makes you look like a developer. And, like subdividing land makes someone look like a developer, subdividing air-space into condominiums, making improvements, and selling them off will make someone look like a developer. This is especially true if the condo conversion begins soon after the apartment building is acquired by the investor.

Now, simply acquiring the approvals and recording a condo map (or whatever document the municipality requires for the subdivision of airspace) should not cause the IRS to classify you as a developer. For instance, in the land context, if you owned a farm for several years, obtained the approvals to rezone and subdivide it, and then sold the entire project to someone else, your 1031 exchange should still be OK. You did not install any infrastructure, nor did you sell individual lots to separate buyers. The same holds true for a condominium conversion. If you obtained the approvals and subdivided the apartment, installed few or no improvements, and sold the whole project off to a single buyer, you still should be fine.

The other main issue to consider is the "year-and-a-day rule." Remember, it is a good rule-of-thumb to hold both your Old Property and your New Property for at least a year and a day before selling. Therefore, if you purchased an apartment, the sure-fire way to pass an audit would be to prove to the IRS that your intent when you purchased the project was to either (1) rent it indefinitely as an apartment, or; (2) perform the conversion and rent the condos out indefinitely. In other words, your intent was to hold the property and rent it out for the foreseeable future. Never, ever, give anyone any indication that you intended to buy the property and later sell off individual units -- no matter how far off in the future such sales may occur. Remember that you cannot do exchanges on property you hold "primarily for sale." The IRS could use this against you.

Going even further, we would recommend that you build a file that describes your intent to hold the property as a rental or investment for the foreseeable future (do not lie, of course -- that could be tax fraud!) Then, if you later change your mind and decide to sell the individual condo units, you are in better shape. Again, we recommend that this not occur for at least a year and a day.

In the end, an apartment-condo conversion is really nothing more than a subdivision. Therefore, if you perform a 1031 exchange, it will naturally have a certain amount of risk. However, by following some of the guidelines above, you will give your project the best chance of surviving an audit.