Commercial property owners want to maximize all of the tax advantages that are available to offset annual taxes and fees. 1031 exchanges offer solutions that can be used for various commercial real estate properties. As you consider acquiring commercial property, it is vital to consult with financial professionals for more information about the solutions that will fit your financial goals.
The information in this article doesn’t constitute legal or financial advice. It is important that you always talk to a professional for personal recommendations. This page is designed to give you an overview of 1031 exchanges and commercial real estate basics so that you can have a knowledgeable conversation when discussing your options.
Tax Benefits for Commercial Property Owners
Taxes are unavoidable. But it doesn’t require that the full burden needs to be carried with each filing. Tax laws allow different strategies to minimize tax impact and assist with the amount that needs to be paid.
One of the biggest tax burdens that hinder profits with real estate investing is the tax on the cash that comes in upon selling a property. When the gain is experienced due to higher property values, then the gain can be subject to federal and state tax laws. This capital gains tax can be one of the biggest expenses faced by investors. Unfortunately, big capital gains taxes can cut into profit margins on the deal.
The financial profit gains on property are calculated by subtracting the price that you paid for the property from the price that you sold the property. For example, if you purchased a property for $1.7 million and sold for $1.8 million, then the financial profit gains would be $100,000. This highly simplistic example ignores other factors that are calculated into the financial profit gains, such as renovations, short-term expenses, money costs, and other costs that are accrued. Most people find that tax considerations are important when buying or selling commercial property.
Luckily, there are flexible investment tools that can be used to avoid some of the heaviest tax impacts. These strategies are legal as long as you are following the guidelines that are established in the applicable laws. Your accounting professionals will assist to ensure that you have the financial information needed to make the best decisions.
Keep in mind that the capital gains tax can’t be avoided completely. Instead, the tax is deferred and can be used almost indefinitely through the 1031 exchange method. The capital gains taxes are deferred until the properties are liquidated by the seller or the investor dies.
Why 1031 Exchanges in Commercial Real Estate?
When a commercial real estate transaction occurs, the seller of the property owes taxes on the money that was gained through the sale. Through the ownership of the property, these gains weren’t taxed over the years. But eventually, the taxes need to be addressed when the transaction occurs.
With 1031 exchanges, it is possible for the seller to defer the gain recognized for the commercial property. Using this strategy means that the gain is re-invested in a similar or like-kind property. Certain restrictions and limitations need to be considered in this transaction. This method can be done legally since the investor doesn’t receive the proceeds of the sale in a way that any money is distributed that needs to be taxed. At this point, the investment is considered the same; it is just changed into a new property.
Investors like the 1031 exchange because of the flexibility that is available in this investment tool. It is a great solution for commercial real estate owners. A 1031 tax-deferred exchange can be done with a single property, or multiple properties can be sold in exchange for one or more replacement properties.
Can You Use a 1031 Exchange?
This exchange strategy can be used in many situations, including individuals, C corporations, S corporations, LLCs, trusts, and other groups that fall under the umbrella of eligibility.
Keep in mind that this exchange strategy is designed to be used for commercial properties. So, you can’t use this method for a private residence, such as your home.
Also, the money that comes from the sale of the first property can’t be simply used for the purchase of a second property. Instead, the two transactions need to be documented and linked to show the IRS that it is all part of the same legal transaction.
Basic Information about 1031 Exchanges
The main idea with 1031 exchanges in commercial real estate is to complete the “like-kind” or similar exchange so that no proceeds are distributed to the investor. Since the proceeds aren’t received, then it is not considered a taxable event based on the code established by the Internal Revenue Service (IRS).
Using a new property to replace an old property maintains the continuity of the investment so that the loss or gain is not recognized when the properties change hands. The gain or loss that is present in the original property is passed to the new, replacement property.
If you are considering this financial strategy, then it is important that you first understand the theory and how the exchange works. Here is some basic information that can assist with your decision and the way the money is handled in the transaction:
- Business or Investment Purposes: The money that you receive must be used in your business or for investment purposes. When an investor has passive property ownership over many years, usually the expectation is that the property value will increase with time due to appreciation. The property needs to be held for these purposes. For example, if a commercial building is purchased with the intention of immediate resale to “flip” the property, then this transaction doesn’t qualify for the 1031 tax exemption.
- Properties that Don’t Qualify: Certain types of properties don’t qualify for 1031 exchanges. This option is not available for assets such as personal residence, vacation home, second home, inventory property, bonds, partnership interests, stocks, stock-in-trade, securities, and more. Also, any properties located outside of the United States do not qualify as “like-kind” property unless the original property and the replacement property are both located outside of the country.
- Similar Exchange: For the exchange to be considered similar (or like-kind) it means that the replacement property needs to be similar to the original property. Additionally, the purpose of the new property should be held for investment or business purposes. Examples include exchanging undeveloped land for a hotel or an office building for a shopping center.
- Comparable Equity: The equity in the new property should be equal or exceed the equity in the original property. When the exchange is completed, the investor is essentially using the property as the medium of the transaction instead of cash. The title of the first property is handed over in exchange for the receipt of the new property. As a result, the investor can defer as much as 20 – 30% of the capital gains taxes that would have been paid in a conventional sale.
- Timing is Flexible: This exchange can happen simultaneously, such as a situation where a swap is completed between two property owners. Or, there are options to defer the tax exchange if the transactions are non-simultaneous. When the exchange is non-simultaneous, then it is common for a taxpayer to use a third-party facilitator who prepares the paperwork, supports the transaction, and holds the proceeds from the sale. Property owners have a window of 45 days from the sale of the original property to find the replacement property. The 45 days is known as an “Identification Period” and must be documented in writing and signed in the 45-day window. The acquisition of the new property needs to happen within 180 days from the sale of the original property. The IRS is strict about following these timelines.
- Same Name on Title: When the replacement property is purchased, it is essential that the same name is used on the title. For example, if you had an LLC that was the name on the original property, then the same LLC should be used for the new property that is purchased.
- Facilitator for the Transaction: Since the sold property needs to be exchanged for the new purchase, it is required that a facilitator or intermediary is used for all 1031 exchanges in commercial real estate transactions.
Parties Involved in the Transaction
As with all real estate transactions, multiple people are involved in this process. Even more, parties need to be included in the transaction for 1031 exchanges for commercial real estate compared with a non-tax deferred transaction.
Here is an overview of the people and parties that are usually involved in a 1031 exchange:
- Investor: You are the person who purchased the property and you are ready to sell it to another party. Other common names for the investor include taxpayer and exchanger.
- Buyer: Who is purchasing the property from you? This person will receive the property deed when the transaction is complete. Money is paid to the intermediary before everything is finalized.
- Intermediary: A third-party needs to be involved in the transaction. This service must be offered by a qualified professional, and the third-party should be neutral. The intermediary cannot be connected to the investor or buyer in any way. For example, you can’t use the attorney or title company that is already involved in the situation. This intermediary acts as the mediator to ensure that the parties are abiding by all regulations. Additionally, the intermediary holds the funds in an escrow account while the details of the exchange are completed.
- Seller: As the investor, you will also have a seller who is providing the new, replacement property to you. It is common to use a 1031 exchange when you sell the original property to one person and buy the replacement property from another property owner.
Other Benefits of 1031 Exchanges in Commercial Real Estate
The core strategy for using 1031 exchanges in commercial real estate is to reduce the tax burden and minimize the out-of-pocket expenses for taxation. But this strategy can be used for a variety of other reasons as well. Even though it might be a complex deal, the exchange can be an excellent method to facilitate overall business strategy.
These are some of the other benefits that can be expected from 1031 exchanges:
- Business Strategy Protection: Since there are absolute deadlines for 1031 exchanges, business strategies can be protected to ensure that the funds are used in the right way for the company. A range of industry experts is now available to assist with the transaction and common issues that arise in these transactions. Leaning on the experience offered by an expert helps you avoid the risk if the preferred deal isn’t satisfactory. The right investment team will have multiple options available as well as a “fallback” plan in case it is necessary to move to plan B.
- Leverage into New Properties: As the real estate market changes with the fluctuations of the economy, exchanges can be used to leverage into an investment property with a higher value. The money that would have been paid to the IRS in taxes can be rolled into the new purchase. As a result, the investor’s overall buying power is improved, and the down payment can be reduced. Real wealth building can occur by stepping into a replacement property that is more expensive.
- Diversification: Exchanges can be flexible, giving investors the option to consolidate several properties into one. Some people use additional strategies to diversify their investments. For example, crowdfunding, partnerships, and commercial real estate fund portfolios are gaining in popularity. These methods are available for investors who don’t have the cash to pay for a commercial property in full without partnering up with other investors.
- Property Management: Acquiring commercial property is just the first step. Next, property management is required. Investors often find that intensive management requirements are burdensome. Instead of getting caught in the daily maintenance and other issues that need to be addressed, high-maintenance investments can be consolidated and rolled into other investment properties using 1031 exchanges for commercial real estate. Many investors find that stress levels drop when the investment money is put into a fund or trust overseen by an experienced manager.
- Optimizing Cash Flow: Adjusting the commercial real estate portfolio can be an essential and important step if you are looking for a way to increase overall income and cash flow in the future. The right exchange can move your investment to a property that offers higher dividends and reduced risk.
4 Types of 1031 Exchanges in Commercial Real Estate
While it seems that a 1031 exchange is a straightforward method when working with the right intermediary, there are actually four types of 1031 exchanges that can be used depending on the situation. Investors can choose the type based on the timeline and properties that are being exchanged:
- Type #1 – Simultaneous Exchange: This exchange happens when the original property and the new property transactions are closed on the same day. This simultaneous method needs to be lined up with exactness to ensure that everything goes through as planned. Even small delays can result in the funds being transferred to an escrow service, which could cause disqualification of the 1031 exchange. Usually, the simultaneous exchange will occur when two parties are swapping deeds on the properties, there is a three-party exchange with an “accommodating party” that facilitates the exchange, or a qualified intermediary is used to structure the transactions.
- Type #2 – Delayed Exchange: A delayed timeline is the most common type of 1031 exchange due to the way the real estate transactions and timelines usually line up. In this situation, the original property is relinquished by the investor before the replacement property is acquired. The property owner secures a buyer and completes the purchase agreement and sale before the delayed exchange is initiated. As mentioned above, the identification of the new property needs to happen in a maximum of 45 days. Then, the purchase of the identified property needs to be completed in 180 days from the sale of the original property. Having an extended timeframe is one of the reasons this method is so common.
- Type #3 – Reverse Exchange: To put it simply, this deal is a “buy first, pay later” strategy. A reverse exchange is a tricky method to use because the replacement property is usually found through an exchange accommodation titleholder. Sometimes it can be hard to get the funding for this purchase since banks don’t often recognize it as a qualifying situation for the loan.
- Type #4 – Improvement Exchange: Exchange equity can be used to make improvements on the replacement property. The funds from the sale of the original property are entrusted to a qualified intermediary. Then, these tax-deferred funds can be used for construction or enhancement of the new property that is purchased. In this situation, all exchange equity needs to be used on improvements that are completed by the 180th day or they can be used as a down payment by this deadline. Also, the investor needs to receive a property that is “substantially the same” based on what was identified by the 45th day. As with other types of deferred exchanges, the replacement property needs to be an equal or greater value compared to the original property. Finally, the construction or improvements that are completed need to be in place before the title is received from the intermediary.
What is the Receipt of “Boot” in the Exchange?
If you want to avoid paying taxes in this exchange, then you need to be careful about the value of both properties so that you don’t receive “Boot.” This term refers to funds that are calculated as the taxable extend of the gains realized.
As an example, if the original property was sold for $2.5 million and the new replacement property is purchased at a price of $2 million, then the $500,000 “boot” is received by the investor and capital gains taxes would apply. The normal tax payments would need to be covered based on the difference in the property price and the money that is received.
Keeping Up with Rules and Commercial Investment Options
It can be a challenge for inexperienced investors to keep up with the various rules and guidelines that apply in the commercial real estate industry. If you want to perform successful 1031 exchanges using commercial real estate, then it is a huge benefit to lean on the expertise offered by professionals who understand the industry.
The tax benefits can be significant when the transaction is completed correctly. As investors learn how to leverage the market and the trends in the industry, then optimal growth and wealth management can be achieved using 1031 exchanges.
It is important that you explore all of your options to avoid depreciation and heavy taxes on your real estate investments. Using the right investment vehicle will affect the profits, distributions, and long-term financial benefits that are available from the investment.
If you’re interested in reading more about 1031 exchange rules, we go more deeply into the topic in another article.
What is the Best Strategy for Your Investment Portfolio?
At First National Realty Partners, we understand that the commercial real estate industry can be confusing for investors who are just entering the arena. We work hard to offer personalized service and attractive investment offerings to make it easier than ever to invest in properties that boost cash flow each month.
If you are interested in learning more about 1031 exchanges and commercial real estate basics, then our team is here to assist. We will gladly answer your questions and help you understand more about the industry. This information can be invaluable so that you can make the right decisions to support your financial growth. Call us at First National Realty Partners to discuss the options that are available. We’re here to help!