Do You Need an Appraisal for a 1031 Exchange?

Generally, no. The rules governing a 1031 exchange do not require a formal appraisal of either the property you sell or the property you buy. In most exchanges the contract price agreed between unrelated parties is treated as the fair market value. Even so, value sits underneath several exchange calculations, and there are situations where an appraisal, whether ordered by you or by a lender, ends up being the most reliable support for the numbers on your return.

Why does value matter in a 1031 exchange at all?

A 1031 exchange is built around comparing what you gave up with what you received. Value shows up in a few places:

• ›Trading equal or up. To defer all of the gain, owners generally aim to buy replacement property of equal or greater value and to reinvest all of the net proceeds. Any shortfall can create taxable boot.
• ›Identification limits. The 200 percent rule caps the combined fair market value of the properties you identify. The 95 percent rule applies if you exceed it.
• ›Personal property. If the sale includes furniture, equipment or other items that are not real property, value has to be allocated between the real estate and everything else.
• ›Form 8824. The return form for an exchange asks for the fair market value of property given up and received.

In an ordinary arm's length sale and purchase, the agreed price usually does that job without anything further.

When is the contract price enough?

When a buyer and seller who are not related negotiate a price, the tax system generally treats that price as fair market value. Both sides had an incentive to push for their own number, so the result is regarded as a reasonable measure.

For most owners selling one rental and buying another from strangers, the purchase agreements and the settlement statements are the main records. Your Qualified Intermediary works from those documents, and your CPA uses them to complete Form 8824. An appraisal adds little in that situation unless a lender wants one.

When might an appraisal be worth having?

There are several situations where the contract price alone may not tell the whole story.

Related party transactions

If you buy from or sell to a family member or an entity you control, the price is no longer the product of opposing interests. Related party exchanges carry their own rules, including a two year holding requirement in many cases. An independent appraisal can help support that the price reflects market value, which matters if the transaction is ever reviewed.

Sales that include personal property

A hotel, a furnished short term rental or a business with real estate attached may include significant personal property. Personal property is generally not like kind to real estate, so its value is usually treated separately and may be taxable. An appraisal or a separate valuation can support how the total price was allocated.

Splitting a property between uses

When part of a property was your residence and part was a rental, such as one unit of a duplex you lived in, the value may have to be divided between the portion that qualifies for a 1031 exchange and the portion that may qualify for the separate home sale exclusion. A defensible allocation is easier with a professional valuation behind it.

Identifying many properties

If you identify more than three properties under the 200 percent rule, you need confidence that their combined fair market value stays under the ceiling. Asking prices can differ from value at closing. When the list is close to the limit, some owners rely on broker opinions or appraisals to judge how much room they have.

Reverse and improvement exchanges

In a reverse exchange or an improvement exchange, a third party called an Exchange Accommodation Titleholder holds title for a time, and construction or renovation can take place during the exchange period. Value at the point the property is transferred to you can matter for whether you have traded equal or up, and supporting documentation may be useful.

Will a lender order an appraisal anyway?

Usually, yes, if you finance the replacement property. A lender appraisal exists to protect the lender, not to satisfy the exchange rules, but it often doubles as useful evidence of value.

It also brings a timing risk. Appraisals can take time to schedule and complete, and a low appraisal can reduce the loan amount or prompt a renegotiation. Both can push a closing toward day 180. Owners who need financing often ask for the appraisal to be ordered as early as the purchase agreement allows.

What happens if the appraisal comes in below the price?

If a lender appraisal comes in below the contract price, the lender typically lends against the lower figure. You then have a few choices: renegotiate the price, bring more cash, accept a smaller loan or walk away if your contract allows it.

Each choice can affect your exchange. Renegotiating down may leave you buying less than you sold, which can create boot. Here is an illustrative example only. An owner sells for 900,000 dollars with 300,000 dollars of debt paid off, leaving 600,000 dollars of net proceeds with the Qualified Intermediary. The owner contracts to buy for 950,000 dollars. The appraisal comes in at 880,000 dollars and the seller agrees to that price. The owner is now buying for 20,000 dollars less than they sold for. Unless another property or additional value makes up the difference, that 20,000 dollars could be treated as boot. These figures are hypothetical, and your CPA can tell you how they apply to your own facts.

Who should order the appraisal?

If you want an appraisal for tax support rather than for a lender, it is usually ordered by you and paid for by you, from an independent appraiser who is licensed in the state where the property sits. It is reasonable to ask your CPA what they would want to see before you order one, so the report covers the right questions, such as the allocation of personal property or the split between residential and rental use.

Keep the report with your exchange records, alongside the purchase agreements, settlement statements, identification form and Qualified Intermediary agreement.

A short way to think about it

For a plain exchange between unrelated parties, the agreed price usually does the job and no appraisal is required. Where the price was not set by opposing interests, where personal property is involved, or where you are working near a limit, independent support for value can be worth having. Ask your CPA and Qualified Intermediary early, before the timeline makes the decision for you.