A 1031 Exchange is a commercial real estate transaction that allows an investor to defer capital gains taxes on the profitable sale of an investment property. For this reason, they are a popular way for investors to allow their real investment portfolio to grow tax deferred over time. But, a 1031 Exchange is a complicated transaction that requires investors to understand a number of complex terms and to follow a series of complicated rules to complete correctly.
In this article, we are going to define what a 1031 Exchange is and review two commercial real estate key terms that are key to completing them, upleg and downleg. By the end, readers will have a more thorough understanding of a 1031 Exchange and should be able to determine if they are a good fit for their unique financial circumstances.
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How Does a 1031 Exchange Work?
In order to understand what the up leg and down leg are, it is first important to understand how a 1031 Exchange works. Specifically, there are two key events.
The first is that an investor has to sell their real estate property. This can happen at any time, but it typically occurs after an investor has held a property for a long period of time and has a potential gain upon sale.
The second part is that, once an investor sells their property, they have 45 days (from the date of sale) to identify a replacement property (that is ”like kind”) and 180 days to close on the purchase of it.
When these two criteria are met – along with the other rules established in section 1031 of the Internal Revenue Code (IRC) – an investor is able to defer their capital gains taxes indefinitely.
Downleg vs Upleg
The terms “upleg” and “downleg” refer to the two different commercial real estate properties in the 1031 Exchange. These real estate properties are often referred to as the Relinquished Property (the property being sold) and the Replacement Property (the property being purchased).
What is the Downleg?
The downleg property refers to the Relinquished Property, which is the property that the investor sells for a gain. It may also be referred to as the Phase 1 property.
What is the Upleg?
The upleg refers to the Replacement Property, which is the property that must be identified within the 45 day identification period under IRS rules. It may also be referred to as the Phase 2 property.
What Downleg and Upleg Mean in the 1031 Exchange Process
In the simplest sense, downleg and upleg are just terms used in the 1031 Exchange process, so they don‘t have any major significance in the facilitation of a 1031 Exchange. But, it is important that investors understand what they mean within the context of a 1031 Exchange, which can promote overall understanding of how a 1031 Exchange works.
What Downleg and Upleg Mean for Commercial Real Estate Investors
As described in the section above, understanding the terms downleg and upleg is an important component when learning how a 1031 Exchange works.
When investors are able to deploy a 1031 Exchange for a commercial property effectively, the implications for a tax return can be significant. To illustrate this point, consider an example.
Suppose that an investor purchases a property for $1MM. After five years, they sell it for $1.5MM – this is the relinquished or downleg property. The difference between the two prices is $500,000 (including depreciation), which is referred to as the gain on sale, and it is taxable. At the time of writing, the highest long term capital gains tax rate is 20%. So, 20% of $500,000 means that this taxpayer could be looking at a tax bill as high as $100,000.
So, the taxpayer faces a choice. They could pay the bill, take the cash from the sale and do something else with it – where they have $400,000 left. Or, they could take the entire $500,000 and complete a 1031 Exchange by reinvesting their funds into a new property – the upleg property. In doing so, they can achieve tax deferral on the entire $500,000 gain, which will allow their money to grow over time. As a bonus, there is no limit to the number of times that this type of transaction can be completed. So, in theory, it could be done over and over again indefinitely, allowing an investor‘s real estate investment capital to grow tax deferred over a long period of time. At the end of 15 or 20 years of 1031 Exchanges, the accumulated tax savings can be significant.
How Qualified Intermediaries Can Help
A 1031 Exchange is a complicated transaction and there are a lot of rules that real estate investors must follow in order to receive full tax deferral. If any of the rules are broken, the transaction can become taxable and the financial consequences can be significant. To avoid this scenario, it is a best practice to use a “Qualified Intermediary”.
A Qualified Intermediary, sometimes called a QI, Facilitator, or Exchange Accommodator, is an individual or firm that is an expert in 1031 Exchange transactions and is hired to advise client(s) on the rules and steps that must be followed to complete the transaction within the bounds of 1031 Exchange rules. Although they charge a fee, their financial and legal advice can be worth every penny to ensure the transaction runs smoothly.
1031 Exchanges & Private Equity Real Estate
For individual real estate investors/property owners, one of the most challenging aspects of a 1031 Exchange can be finding suitable replacement properties within the required time frames and due dates. The competition for the best properties can be significant and it takes time to visit, analyze, and assess potential options.
For this reason, it can be a good idea for investors to work with a private equity firm to help make this process a bit easier. In this scenario, the firm can assist with the purchase of a like kind property, within the allowable exchange period, by offering an ownership structure known as “tenants in common.” In such an arrangement, investors can purchase a fractional share of identified properties, which allows them to close on the replacement property quickly and gain exposure to an institutional quality asset. In addition, the private equity firm typically manages many of the logistics and the property itself, which makes for a truly passive investment option.
Summary of Downleg and Upleg
In a 1031 Exchange, investors can defer capital gains taxes on the profitable sale of a real property as long as they reinvest the proceeds into a like kind property.
The real estate terms downleg and upleg refer to the two distinct phases of 1031 property exchanges.
Downleg refers to the property that is sold. It is sometimes referred to as the Relinquished Property or Phase 1 property. The sale of the downleg triggers the beginning of the 1031 Exchange process.
Upleg refers to the property that is purchased in the second phase of the transaction. It is sometimes referred to as a replacement property.
Understanding these terms and their significance in a 1031 Exchange transaction can help investors gain an understanding of how these transactions work.
While 1031 Like-Kind Exchanges can be incredibly helpful from a tax perspective, they are also complicated. It is a best practice to work with both a Qualified Intermediary and tax advisor to ensure that this type of transaction is suitable and that it runs smoothly.
Interested In Learning More?
First National Realty Partners is one of the leading private equity commercial real estate investment firms in the United States. We leverage decades of expertise to find world-class, multi-tenanted assets available 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 investment opportunities, contact FNRP at (800) 605-4966 or firstname.lastname@example.org.