One of the most commonly cited benefits of a commercial real estate investment is the potential tax savings that can be realized. Specifically, there is one tax savings program – known as a 1031 Exchange – that allows investors to defer capital gains taxes as long as they reinvest their sales proceeds into another property that is “like kind” to the one that was sold.
In this article, we will describe the 1031 Exchange process, define exactly what a “like kind” property is, and review the rules that must be adhered to in order for investors to achieve full tax deferral. By the end, readers will have the information necessary to determine if the 1031 Exchange process is a good fit for their own investment objectives.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail centers, which qualify as a like kind property in a 1031 Exchange. If you are an accredited investor looking to deploy 1031 Exchange funds and would like to learn more about our current investment opportunities, click here.
The 1031 Exchange Process Explained
The timing of the 1031 Exchange process begins when an investor sells their property.
The sold property is known as the “relinquished property” and investors have 45 days – from the date of sale – to identify a suitable “replacement property” and 180 days from the date of sale to complete the purchase of it. When they do this, investors can defer capital gains taxes on a profitable sale as long as the transaction meets several key criteria:
- Purpose: Both properties (the relinquished and replacement) must be held for use in a trade or business or for investment purposes. Property with a personal use, like a primary residence or vacation home, does not qualify for like-kind exchange treatment.
- Value and Equity: The value of the relinquished property and the equity in it must be the same as or greater than the replacement property. For example, if the relinquished property has a value of $1,000,000 and equity of $250,000, the replacement property must have a purchase price of at least $1,000,000 and equity of at least $250,000.
- Same Taxpayer: The taxpayer/property owner for the relinquished property and the replacement property must be the same.
- Property Cannot be Held for Sale: IRS rules state that the replacement property must be held for productive use in a trade or business or for investment. They cannot be “held for sale” meaning that they cannot be purchased for the tax benefits and then immediately sold. As a general rule, they should be held for a minimum of 12-24 months.
- No Boot: “Boot” is the fair market value of cash or “other property” received in a 1031 Exchange. If it is received, it is taxable.
- Diversification: How many properties can you identify in a 1031 exchange? Properties do not necessarily have to be exchanged on a 1:1 basis. For individuals looking to diversify their investment portfolio, one property can be exchanged for many as long as the following rules are met:
- Rule of Three: The exchanger can identify up to 3 like kind replacement properties
- 200% Rule: The exchanger can identify unlimited properties as long as their cumulative value does not exceed 200% of the market value of the relinquished asset.
- 95% Rule: The exchanger can identify more than three properties whose value exceeds 200% so long as they acquire 95% of the value of the replacement properties.
- Like Kind: Finally, and perhaps most importantly, the replacement property must be “like kind” to the relinquished property.
If any of the above rules are broken in the 1031 Exchange process, it may become ineligible for tax deferral. But, this can be easier said than done because the details of the above requirements are not clearly defined – particularly those surrounding the definition of a like kind property.
What is a Like Kind Property?
As described above, one of the key rules in a 1031 Exchange is that the replacement property has to be “like kind” to the relinquished property. But, what does this mean specifically?
According to the IRS, “like kind” means that both the relinquished property and replacement property must be “of the same nature, character, or class.” The quality or grade of the property does not matter, which means that most real estate investment properties are “like kind” to other real estate investment properties as long as both are located in the United States.
In the definition of “like kind,” there are certain asset types/properties that are specifically called out as not being like kind to real estate. They include:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
If there is any doubt about whether a property is like kind, it is a best practice for real estate investors to consult an attorney who specializes in 1031 Exchanges or a qualified intermediary.
1031 Exchanges and Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust – DST for short – is a specialized type of company that is set up for the purpose of purchasing an institutional quality real estate asset. Individual investors can buy shares in the trust, which entitles them to their pro rata share of the income and profits produced by the underlying property.
With regard to 1031 Exchanges, IRS Revenue Ruling 2004-86 clarifies that an investment in a DST qualifies as “like kind” in a 1031 Exchange. For individual investors, this is important for three reasons:
- Speed: Because a 1031 Exchange has to be completed within a relatively short window of time, competition for the best replacement properties can be intense. Using a DST investment as a replacement property solves this issue.
- Quality: A DST allows individual investors to purchase a fractional share of an institutional quality asset. For many this is an attractive alternative to purchasing a lesser quality property on their own.
- Management: In a DST investment, the entire transaction is managed by a third-party firm. For individual investors, this can be a major time saver.
The important point is that DSTs can be used as a replacement property in a 1031 Exchange, which can provide several important benefits over purchasing a property directly.
1031 Exchange Example
To illustrate how all of these rules work together, an example is helpful.
Suppose that an investor is eying the sale of a small retail center that they have owned for 25 years. Their cost basis is $500,000 and the property sells for $1,500,000 on January 1st, which equates to a taxable gain of $1,000,000. To defer the tax liability on their gain, the investor decides to do a 1031 Exchange.
From a timing standpoint, the investor must identify their replacement property by Feb 14th (45 Days) and must close on the purchase of it by June 29th (180 Days).
From a financing perspective, the value of the new property must be at least $1,500,000 and the investor must invest all of their $1,000,000 equity. It could also be invested in multiple properties as long as the totals align.
The replacement property could be another retail center. Or, it could be an office building, apartment building, or industrial rental property, as long as it is real property, in the United States, and held for productive use in a trade or for business or investment.
Private Equity & 1031 Exchanges
Given the rules and time limits involved, a 1031 tax deferred exchange can be a complicated transaction. For this reason, it is usually a good idea for individual investors to work with a professional exchange facilitator that has specific 1031 Exchange transaction expertise. In some cases, this could be a qualified intermediary. In other cases it could be a private equity firm like ours.
For an individual investor, the benefit of working with a private equity firm is that they can assist with all of the major parts of the transaction, including finding a replacement property, arranging the purchase, lining up the financing (if needed), and managing the property once the transaction is complete. In addition, the firm’s expertise ensures that the transaction is completed on time and that it follows all 1031 Exchange rules.
Summary of 1031 Exchange Properties
A 1031 Exchange, named after a section in the Internal Revenue Code, is a type of transaction that allows investors to defer capital gains taxes on a profitable sale as long as the proceeds are “exchanged” into another property of like kind.
In order to qualify for full tax deferral, investors must follow a series of complex rules regarding the timing of the transaction and what exactly qualifies as a like kind property.
A like kind property is one that is of the same nature, character, or class as the property that is sold. As long as both properties are located in the US, most commercial real estate is like kind to other commercial real estate, regardless of the type of property.
A specific type of investment known as a Delaware Statutory Trust also qualifies as a like kind replacement property in a 1031 Exchange.
Because the 1031 Exchange process can be complex and the consequences of not following the rules can be costly, it is a best practice for individual investors to work with an expert to complete them. These experts could include a qualified intermediary, real estate broker, real estate agent, attorney, or private equity firm like ours.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, 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 would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.