There is a common misconception about 1031 Exchanges that one real estate property must be “exchanged” for another property. While this is certainly the case in many transactions, it is certainly not the case in all of them.
In this article, we are going to describe what a 1031 Exchange is and how it can be used to exchange one property for multiple properties. By the end, readers will have a greater understanding of how 1031 Exchanges work and will be able to incorporate this knowledge into their tax planning strategies.
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What is a 1031 Exchange?
In order to understand how a 1031 Exchange can be used for multiple properties, it is first necessary to understand exactly what a 1031 Exchange is.
A 1031 Exchange is a type of real estate transaction that allows an investor to defer capital gains taxes on the profitable sale of an investment property. In it, an investor sells one property (the “relinquished property”) and can defer taxes on the gain as long as they reinvest the sale proceeds into another property (the “replacement property”) that is considered to be “like kind” to the one that was sold. As a general rule, most commercial real estate is considered to be like kind to other commercial properties.
Calculating Gains from a 1031 Exchange
As the description above suggests, the key figure in a 1031 Exchange is the amount of the gain so it is important to understand how it is calculated.
The exact calculation of a gain can be very complex because it is highly dependent upon things like the purchase price, accumulated depreciation, and the sale price. But, in general, a gain is calculated as the difference between a property’s “cost basis” and the amount of the sale.
For example, assume that a property was purchased for $1MM. Also assume that it was held for 10 years and that the property owner took $20,000 per year in depreciation. At the end of 10 years, the cost basis would be $800,000 ($1,000,000 – ($20,000 * 10)). Now, assume that it was sold for $2MM at the end of the 10 year time frame.
In this hypothetical scenario, the “gain” on sale is the difference between the cost basis of $800M and the sales price of $2MM – $1.2MM. This is the amount that becomes taxable. Given the size of the gain, it is understandable that real estate investors want to defer it into the future.
1031 Exchange Rules
In order to achieve full tax deferral in a transaction, the IRS has established a number of rules that 1031 Exchange participants must abide by. Among the most prominent are:
- There is a 45 day identification period in which investors must identify their replacement properties. Once identified, the purchase must be consummated within 180 days of the sale of the relinquished property.
- The replacement property must be of equal or greater value than the relinquished property. And, the investor must invest 100% of their gain. So, for example, if an investor had a property worth $1MM that has a $500M mortgage, the entire $500M must be reinvested into the replacement property. It could be another $1MM property with a $500M mortgage. Or, it could be a $2.5MM property with a $2MM mortgage. Equal or greater value.
It is the second point above where the common misconceptions occur. The property exchange could be one for one as described. Or, it could be one for many as long as the exchange continues to meet one of three rules.
Exchanging Into Multiple Properties
There are a number of reasons why an individual may want to exchange one property for multiple, but the most prominent is to diversify their portfolio. For example, assume that an investor owns a small office building for 20 years and ends up with a $2MM gain. Instead of reinvesting all of the gain into another office building, they could use it to buy a small office building plus an apartment building, retail property, or industrial warehouse. Once complete, the taxpayer has successfully transitioned their real estate portfolio from one property into several, which has diversified their portfolio and lowered risk.
When exchanging into multiple properties, the internal revenue code lays out three rules that investors must abide by.
Rule #1: The Three Property Rule
IRC Section 1031 allows investors to identify up to three replacement properties. They do not necessarily have to purchase all three properties, but they do have to be identified within the 45 day identification period.
Rule #2: The 200% Rule
Under the 200% rule, investors can identify more than three exchange properties as long as their aggregate value does not exceed 200% of the sales price of the relinquished property.
For example, if an investor sells one property for $1MM, they could identify five replacement properties as long as their aggregate value does not exceed $2MM.
Rule #3: The 95% Rule
If an investor identifies more than three replacement properties, with a total value that is more than 200% of the value of the relinquished property, 1031 Exchange rules state that they must close on at least 95% of the total fair market value.
Working With Professionals
A “vanilla” 1031 Exchange transaction is complicated by itself. When attempting to complete a one to many real estate property exchange, it becomes even more so. As a best practice, 1031 Exchanges should not be completed by individuals on their own. Instead, they should be completed in partnership with professionals like tax advisors, CPAs, and, most importantly, Qualified Intermediaries (QIs) to ensure that all necessary rules are followed. If rules aren’t followed, it can be very costly in the sense that the transaction may not achieve full tax deferral.
What This All Means for Investors
A one to many 1031 Exchange can provide several potential benefits to an investor. They include:
- Tax Deferral: There is no limit on the number of times a 1031 Exchange can be completed. As a result, investors can theoretically defer capital gains taxes indefinitely, allowing their investment capital to grow tax free over a long period of time.
- Diversification: As described above, a one to many exchange can help investors diversify risk in their portfolio. This diversification can come in many forms including: property type, property location, tenant base, or property size. In short, it can be an effective risk mitigation strategy.
- Estate Planning: With the proper planning, a 1031 Exchange can be an effective way to pass assets on to heirs because they inherit them at a stepped up cost basis, which can also help with taxes.
- Higher Value Properties: As an investor’s capital grows over time, a 1031 Exchange can be used to move up to owning a series of higher value rental properties, without incurring the tax bill of a profitable sale.
While these benefits can be significant, they aren’t without risk. Potential risks of a multi-property 1031 Like Kind Exchange include not being able to identify a potential replacement property within the allotted time frame; not following the identification rules, causing the transaction to become taxable, or working with an inexperienced qualified intermediary, which can also cause the transaction to become taxable.
Is a 1031 Exchange Right For You?
Every individual has their own unique set of investment needs and priorities. For this reason, it is difficult to say whether or not a 1031 Exchange is the right transaction for every individual.
Instead, investors should take stock of their own investment priorities, the circumstances of their individual tax situation, the characteristics of their property, and their desire to purchase another new property. In addition, they should consult with their CPA and/or tax advisors to make a final decision.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.