1031 Exchanges: Commercial Real Estate Basics
In an ideal commercial real estate investment, an investor purchases a property for a certain amount of money, holds it for some period of time while collecting periodic income, and then sells it for a price that is higher than the one paid. This scenario is “ideal” because the investor turns a profit, but the downside is that they also have to pay taxes on the profit, which makes it smaller, sometimes significantly so. Fortunately, there are strategies that investors can pursue to defer these taxes over time.
In this article, we are going to discuss one such strategy known as a 1031 Exchange. In doing so, we will describe what it is, how they work, why they are beneficial, and the risks to look for. By the end, readers will have the information needed to determine if a 1031 Exchange is a good fit for their own needs.
At First National Realty Partners, we are a private equity firm who specializes in the purchase and management of grocery store anchored retail centers. We work with many investors to complete 1031 exchanges and have deep expertise in this area. If you are an accredited investor, interested in partnering with a private equity firm to allocate capital to a commercial real estate investment, click here.
1031 Exchange Scenario
In order to understand what a 1031 Exchange is, it is helpful to provide a typical scenario in which one may be used.
Suppose that an individual investor purchases a small retail property for $1,000,000. Over the course of 10 years, they operate it and collect rent, while utilizing depreciation to reduce the cost basis to $800,000. At the end of 10 years, they have moved to a new phase of their life and sell the property for $1,250,000.
The difference between the cost basis at the time of sale, $800,000, and the sales price, $1,250,000, is $450,000, and this is classified as a “gain on sale” and is taxable. The exact amount of taxes due is dependent upon a number of factors including how long the property was held and the tax bracket of the seller, but for the sake of this example, assume that the tax rate is 25%, which means that the investor in the example has incurred a tax bill of $112,500.
Depending on what the investor’s financial needs are at the time of sale, they may choose to pay the taxes, which significantly reduces their profit. Or, they could choose to defer their tax bill using a 1031 Exchange.
What Is a 1031 Exchange in Commercial Real Estate?
A 1031 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of a property, as long as they “exchange” the sale proceeds into a “like kind property.” This type of transaction is sanctioned under section 1031 of the Internal Revenue Code and is a popular way to minimize taxes on a successful investment.
In order to receive full tax deferral in the exchange, there are a number of rules that investors must follow.
1031 Exchange Rules
The complete list of rules for a 1031 Tax Deferred Exchange is described in the internal revenue code section of the same name, but the most important ones to remember include:
- Property Type: The tax code does not explicitly state which types of properties are eligible, instead it states that the property must be “…held for productive use in a business or trade, or for investment.” Under this test, nearly all commercial properties are eligible, but there may be some restrictions on a personal residence, secondary home, or vacation home.
- Like Kind: The property sold, referred to as the relinquished property, and the property purchased, known as the replacement property, must be like kind. Again, the tax code does not explicitly define which property types are like kind, instead it says they must be “of the same nature or character.” Most commercial property is kind to other commercial property.
- Time: Within 45 days of the sale of the relinquished property, real estate investors must formally identify the replacement property that they plan to purchase. Within 180 days, they must close on the purchase.
- Value: The value of the replacement property must be equal to or greater than the value of the relinquished property and the debt and equity must also be comparable.
- Location: Both the relinquished property and the replacement property must be located within the United States, but there are exceptions that allow for foreign property inclusion.
- Title: Both the replacement property and the relinquished property must be titled in a similar manner.
Given these rules, it is easy to see that a 1031 Exchange can be a complex transaction. As such, it is always a best practice to work with a “Qualified Intermediary” who is an expert in the rules and will guide investors through the process from beginning to end. Doing so will help keep investors from violating one of the rules and causing the transaction to become taxable.
Why Investors Like 1031 Exchanges
The biggest and most important reason why investors/taxpayers like 1031 Exchanges is the deferral of capital gains taxes, which allow them to grow their capital, tax free over a long period of time. Other reasons to like 1031 Exchanges include:
- Repetition: There is no limit to the number of times a 1031 Exchange can be completed. In theory, an investor could complete them over and over again, deferring capital gains taxes indefinitely.
- Choice: With the ability to complete a series of successive 1031 Exchanges, investors have a choice as to when they want to incur taxes, which can be very helpful for financial planning purposes.
- Diversification: There are certain provisions within 1031 Exchange rules that allow investors to exchange one property for multiple properties as long as certain parameters are met. So, for example, an investor could exchange a retail shopping center for an apartment building and an office building, allowing them to diversify their investment portfolio.
- Estate Planning: Tax rules allow heirs to inherit like kind exchange properties at a stepped up cost basis, which can be very useful for estate planning purposes.
For all of these reasons, a 1031 Exchange can be a very effective way to manage investment tax liability.
Who Is Eligible to Use a 1031 Exchange?
IRS rules state that that following are eligible to complete a 1031 Exchange:
“Owners of business and investment property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.”
Which Properties Qualify for 1031 Exchanges?
As described in the section above, the properties involved in a 1031 Exchange must be “held for use in a trade or for business or for investment..”
As such, IRS rules specifically state that “…Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.
Both properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception to note is that property located within the United States is not like-kind to property located outside of the United States.
Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of: Inventory or stock in trade; stocks, bonds, or notes; Other securities or debt; Partnership interests; Certificates of trust.
Parties Involved in the 1031 Exchange Transaction
In a typical 1031 Exchange transaction, there are three parties involved, the investor/seller, the buyer, and the Qualified Intermediary.
The first, and most obvious party is the investor/seller of the property. This is the individual or corporation looking to complete the 1031 Exchange, which begins with the sale of the relinquished property.
Of course, if the relinquished property is going to be sold, there must be a buyer for it.
The Qualified Intermediary is the party that is the expert in the 1031 Exchange rules and they work with the investor to manage the entire exchange process from beginning to end to make sure it stays in compliance with applicable tax laws. In addition, the “QI” may also manage the escrow process, take title to the property, and complete all of the paperwork necessary to complete the exchange.
Types of 1031 Exchanges
Because every transaction is unique, there are four types of 1031 Exchanges that can be used to defer taxes.
As the name suggests, a simultaneous exchange is one where the relinquished property is sold and the replacement property is purchased simultaneously – usually on the same day.
This is a good option for investors who already know which replacement property they want to purchase.
A delayed exchange is the most common type and it is the one described above. In it, the relinquished property is sold first, then the investor has 45 days to formally identify the replacement property and 180 days to close on the purchase of it.
This type of exchange is good for investors who know they want to sell their property, but haven’t yet formally identified a replacement.
In a reverse exchange, the replacement property is first identified and purchased. Then, the relinquished property is chosen and sold.
This type of exchange is best for investors who know which replacement property they want to purchase, but haven’t yet decided which property to sell. Or perhaps, they know which property they want to sell, but need to prepare it for sale.
In a construction exchange, investors are allowed to use some of their sale proceeds to complete construction improvements on the replacement property. However, the improvements cannot be significant because the same time frame applies and there is only so much that can be accomplished within it. Usually, a construction exchange is used to modernize or customize a property for the new owner’s needs. For example, a retailer may need to complete a buildout of the interior to match their branding standards, or a manufacturer may need to prepare the space for their equipment.
The driving factor behind the choice of the 1031 Exchange type is the unique circumstances of the transaction. If there is any doubt, it is always a good idea for an investor to consult a tax advisor or CPA.
1031 Exchange FAQs
To further assist with the understanding of the 1031 Exchange transaction, below are the answers to some frequently asked questions.
Is it Possible To Complete a 1031 Exchange on a Primary Residence?
No. Remember, the property must be held for business or investment purposes. Under this test, an investor’s primary residence does not qualify.
What is an Example of a 1031 Exchange?
A1031 Exchange can be completed under a number of different scenarios, but a common one involves small business owners. Suppose that an individual starts a small importing business importing products and purchases their own warehouse. But, after several years, they have outgrown their space and need a new one. So, the business owner sells their current warehouse for a profit and utilizes a 1031 Exchange to buy a new one and defer capital gains taxes on the profit.
Can You Do A 1031 Exchange For Multiple Properties?
Yes, it is possible to complete a 1031 Exchange where one property is exchanged for multiple properties as long as the transaction meets a number of criteria.
First, the “three property rule” states that investors can identify up to three properties as potential replacements and can close on the purchase of one, two, or three of them.
Second, if the investor wants to identify more than three properties as replacements, they can do so as long as the combined fair market value of the identified properties does not exceed 200% of the value of the relinquished property.
Finally, the 95% rule states that an investor can identify more than three properties, with a aggregate value that is more than 200% of the value of the relinquished property, but only if they close on 95% of the value of the properties identified.
Combined, these rules give investors multiple avenues to complete a one to many 1031 Exchange.
How Do You Report a 1031 Exchange to the IRS?
Once complete, investors are required to report the 1031 Exchange on Form 8824 and include it as part of their annual tax return for the year in which the exchange occurred. According to the IRS, Form 8824 asks for information about the exchange including:
- Descriptions of the properties exchanged
- Dates that properties were identified and transferred
- Any relationship between the parties to the exchange
- Value of the like-kind and other property received
- Gain or loss on sale of other (non-like-kind) property given up
- Cash received or paid; liabilities relieved or assumed
- Adjusted basis of like-kind property given up; realized gain If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.
It is important to note that the form must be completed accurately, and fully. Failure to do so could disqualify some or all of the exchange. For this reason, it is important to utilize the services of a Qualified Intermediary, sometimes called an exchange facilitator. They can assist with the preparation of the paperwork to ensure it meets all requirements.
How Can I Change Ownership of Replacement Property After a 1031 Exchange?
Remember, one of the most fundamental rules of completing a 1031 Exchange is that both the replacement property and the relinquished property must be titled similarly. As such, it is generally inadvisable to change the ownership of the replacement property once the 1031 Exchange has been completed.
However, if sufficient time has passed – 2 years or more – it may be allowable to change the ownership without an impact to the original tax deferral. However, it is critical to note that all transactions are different and any attempt to change ownership could result in the disqualification of the original exchange. As such, it is a best practice to work with a CPA and/or tax attorney to ensure that there will not be a tax impact to a transfer of ownership after completion of an exchange.
What is the Receipt of “Boot” in a 1031 Exchange?
It has a funny name, but serious financial consequences. In a 1031 Exchange, “boot” is any non-like kind property received in the exchange. Typically, it comes in the form of cash, stocks, bonds, notes, ownership interests, or debt relief. Because these assets are non-like kind, they can be taxable if received. Again, this highlights the importance of working with a qualified intermediary because they can advise property owners if the boot is taxable.
Summary of 1031 Exchanges
A 1031 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as the proceeds are used to purchase another, like kind property.
The rules for completing a 1031 Exchange are outlined in section 1031 of the Internal Revenue Code and they must be followed precisely to ensure the transaction is fully tax deferred.
In addition to the allowable tax deferral, investors like 1031 Exchanges because they can also be a way to diversify an investment portfolio, plan for inheritance, and control when taxes are incurred in a transaction.
For investors interested in completing a 1031 Exchange, it is a best practice to seek advice from a CPA or tax attorney and to work with a Qualified Intermediary to make sure the transaction runs smoothly.
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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.