From Houses to Commercial: Exchanging a Residential Portfolio Into Commercial Property

The exchange itself is simple: houses and commercial buildings are like-kind

Reg. section 1.1031(a)-1(b) looks only at whether property is real estate, not at its use or quality, and gives city real estate for a ranch or farm as a like-kind example. A rental house, a duplex, a strip center and a warehouse are all the same kind of property for section 1031.

The usual rules apply. Identify within 45 days, close within 180, and buy at least as much as you sold, with at least as much debt or added cash, to defer all of the gain. Selling several houses to buy one building raises sequencing questions covered in one property into several or several into one and consolidating rentals into one.

Depreciation slows: the basis you carry over is recovered over 39 years, not 27.5

Section 168(c) gives residential rental property a 27.5-year recovery period and nonresidential real property 39 years. A building is residential rental property only if 80% or more of its gross rental income comes from dwelling units, so a mixed-use building that fails that test is depreciated as commercial.

For the basis carried over from your houses, Reg. section 1.168(i)-6(c)(4)(i) says that when the replacement has a longer recovery period, the exchanged basis is depreciated as if the replacement had been placed in service when the relinquished property was, but using the longer period. In practice the remaining deductions spread out. Paragraph (i) lets you elect out and treat the carried-over basis as newly placed in service.

Any extra basis from new debt or added cash is new property depreciated over 39 years. Hypothetical: $1,000,000 of new building basis yields about $25,641 a year over 39 years against $36,364 over 27.5 years, roughly $10,700 a year less in deductions. Run your own numbers with your CPA.

Recapture works the same way on both sides, so the move does not create a new tax layer

Residential and nonresidential real property placed in service after 1986 are depreciated straight line, and Publication 544 explains that straight-line depreciation on section 1250 property produces no additional depreciation to recapture as ordinary income. The depreciation you took on the houses becomes unrecaptured section 1250 gain, taxed at up to 25% under section 1(h) when you eventually sell for cash.

In a fully deferred exchange that layer rides into the commercial property's basis. If you used cost segregation on the houses, components treated as section 1245 property can bring ordinary recapture; section 1245 recapture in real estate covers when that applies.

Leases and loans are where commercial property really differs from houses

A house is re-leased every year or two to a household. A commercial building is leased for several years to a business, often with the tenant paying taxes, insurance and maintenance under a net lease, and with rent steps and renewal options written into the lease. That stability cuts both ways: a lost tenant can mean a long vacancy, tenant improvement costs and leasing commissions before rent resumes.

Your loan changes too. A commercial lender looks at the building's leases, the tenants' credit and the lease expiration schedule rather than mainly at your personal income. If you are replacing debt as part of the exchange, start that underwriting before day 45; the 1031 in a high-rate market covers how rates change the debt-replacement math.

The type of commercial property matters as much as the move itself. Retail strip centers, office buildings and industrial warehouses each carry different tenant and leasing risks.

Worked model: four houses into one net-leased building and two DSTs, with the debt replaced

Hypothetical round numbers to show the mechanics. Your own figures will differ, so run your own numbers with your CPA before you identify anything.

• Four houses sell for a combined $1,600,000 with $100,000 of selling costs, so the amount realized is $1,500,000. Their mortgages total $400,000, leaving $1,100,000 with the qualified intermediary.
• To defer all the gain, the replacements must total at least $1,500,000 and carry at least $400,000 of debt, or the shortfall in debt must be covered with added cash.
• One path: a $900,000 single-tenant building bought with $500,000 of exchange cash and a $400,000 loan, plus $600,000 split between two DST interests. Each DST's allocated loan also counts toward replacement debt, explained in DST loans as replacement debt.
• The result is one property you own and oversee, and two passive interests in other property types, instead of four houses with four sets of tenants.

DST interests and single net-leased buildings are the usual first step into commercial property

Owners moving from houses often have no experience leasing commercial space. A DST interest in a commercial property counts as real property under Rev. Rul. 2004-86, with the leasing, financing and management already in place, and the sponsor deciding when to sell. A single-tenant net-leased building gives you direct ownership with fewer landlord duties than a multi-tenant property, but concentrates all the income in one tenant; see buying a NNN property for retirement.

Our traditional DST offerings include medical office, industrial, self-storage and multifamily properties, typically at $100,000 to $250,000 per offering, so a portfolio of houses can be split across commercial and residential interests. Distributions are not guaranteed, and DST interests are illiquid until the sponsor sells.