A profitable commercial real estate investment is a double edged sword. On one side, the property owner is happy that they were able to sell their asset for more than they paid. But, that profit can also come with a big tax bill from the IRS when they file their tax return. As such, there are a variety of strategies that experienced investors use to minimize or defer their tax liability when they sell a property. One of the most popular is known as a “1031 Exchange.”
What is a 1031 Exchange?
A 1031 Exchange, also known as a “Like Kind Exchange” is a tax deferral strategy used by experienced investors to defer tax liability/income tax on the profitable sale of an investment property. The “1031” in the name refers to the section of the Internal Revenue code that permits them, which states “…no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind…”
In other words, the capital gains taxes on a profitable sale are deferred as long as the proceeds from the “Relinquished Property (the property being sold)” are reinvested into a “Replacement Property (the new property being purchased)” that is considered to be “like kind.” A 1031 Exchange can be completed with any commercial real estate property type including, multifamily/apartment buildings, retail, industrial or office. Under certain circumstances, they can also be used with a primary residence or rental property, but these exchange transactions are complicated and the exception to the rule. Business property cannot be exchanged.
In theory, an investor can defer taxes indefinitely by completing a series of successive 1031 Exchanges. This type of tax deferral can provide a powerful incentive for continued real estate investment, but they must be done correctly and within the bounds of the tax code to receive the full tax benefits.
1031 Exchange Rules
The fine print of section 1031 outlines a series of rules and requirements that must be met to complete the exchange correctly:
- Like Kind Test: The replacement property must meet the “like kind” test which states that it must be “of the same nature or character” as the relinquished property. In addition, it must be located in the United States and held for “productive use in a trade or business or for investment.” It should be noted that the rules do not make a distinction between property types. So, for example, an office building could be exchanged for an apartment building and it would still meet the “like kind” test.
- Time: From the sale date of the relinquished property, potential replacement properties must be identified within 45 calendar days (the “identification period”) and the purchase of the replacement property must be completed within 180 calendar days. This is a relatively short time frame and competition for the best properties can be stiff so it is important to get started early and use a real estate agent if necessary.
- Value: 1031 Exchange rules state that the market value and equity of the replacement property be the same as, or greater than, the value of the relinquished property. For example, a property with a value of $5M and a mortgage of $3M must be exchanged into a property with a purchase price of at least $5M with $3M worth of debt. If it isn’t the difference could be taxable.
- No “Boot”: The term “boot” refers to any non-like kind property received in a 1031 Exchange. For example, it could take the form of cash, installment notes, debt relief, or personal property and it is valued at “fair market value.” If boot is received, it doesn’t disqualify the exchange, but it could make it taxable.
- Held For Sale: The replacement property cannot be “held for sale.” In other words, it can’t be purchased for the tax deferral benefits and then immediately sold. 1031 Exchange rules do not define a specific period of time that the replacement property must be held for, but it is generally agreed that a minimum of 12-24 months is a best practice.
- Same Taxpayer: The taxpayer associated with the relinquished property must be the same as the one associated with the replacement property. In addition, both properties need to be similarly titled.
Depending on the unique circumstances of the transaction, the exchanger may seek to use one of four 1031 Exchange types: delayed exchange/deferred exchange, reverse exchange, simultaneous exchange, or construction exchange. Regardless of type, there are several benefits to taking advantage of the 1031 Exchange program.
1031 Exchange Benefits
Aside from the obvious tax deferral advantages, there are a number of ancillary benefits that real estate investors can realize from using a 1031 Exchange:
- Diversification: 1031 Exchange rules do not require a one-for-one swap, which means that they can be used as a vehicle for increasing the diversification of a real estate investor’s portfolio. Specifically, section 1031(k)-1(c)(4) of the code states that “…the maximum number of properties that a taxpayer may identify is:
- Three properties without regard to the fair market values of the properties (the 3-property rule), or
- Any number of properties as long as their aggregate fair market value…does not exceed 200% of the aggregate fair market value of all relinquished properties (the 200% rule).”
- Tax Deferred Growth: Using a 1031 Exchange to defer taxes on profitable investments allows for the tax-free/tax deferred growth of investment capital. With each exchange, the investor is able to purchase a more expensive property than they would have been able to had taxes been paid.
- Property Replacement: Instead of investing significant sums into the renovation of an existing property, a 1031 Exchange can be a way to replace a physically obsolete property with a newer, more efficient one.
Although the benefits of a 1031 Exchange can be substantial, there are a number of risks that an investor should be aware of.
1031 Exchange Risks
The primary risk in a 1031 Exchange is that it isn’t completed correctly and the mistake causes the transaction to become taxable. For example, if a replacement property is not identified within the allocated time period or the transaction runs into delays and it cannot be closed within 180 days, the deferment could be nullified and taxes must be paid.
The other major risk to consider is the use of a third party “Qualified Intermediary.” These are experts in 1031 Exchanges and they are employed to act as a facilitator for buyers and sellers. As part of their responsibility, they actually facilitate the exchange of property titles between the buyer and seller. In addition, they hold exchange proceeds in escrow until they are needed to purchase the replacement asset. In other words, they play a critical role in the transaction, but they are unregulated by the Federal Government and receive little oversight from any other regulatory body or trade association. Although rare, it is not unheard of for a Qualified Intermediary to go out of business or to engage in fraudulent behavior that puts the exchange (and the investor’s capital) at risk.
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.
We have a significant amount of experience in dealing with 1031 Exchange related transactions. Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our middle market retail investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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