- When a real estate investor sells a property, their enthusiasm over making a profit can quickly give way to frustration over a large capital gains tax bill.
- Savvy investors can defer the capital gains tax by utilizing a transaction known as a 1031 Exchange.
- A 1031 Exchange – so named for the section of the IRS tax code that sanctions it – allows an investor to defer taxes on a gain as long as they “exchange” the sales proceeds into another property of like kind. There are four types of 1031 Exchanges.
Imagine this scenario, an individual real estate investor purchases an investment property in an industrial location. For years, they lease the space in it to a variety of tenants and earn just enough money to make the mortgage payment, but not much else. However, over time, the industrial location becomes hip and it becomes inhabited by artists and creative professionals who open top tier restaurant and entertainment locations.
One day, the investor gets a knock on their door from a developer who wants to purchase their industrial rental property and transform it into high end condominiums. They are willing to pay a premium price and the decision to sell is a no brainer. They sell the property at a significant profit.
The situation described above is a common one. But, in many cases, the initial enthusiasm for the large profit quickly gives way to some level of frustration because big profit also means a big capital gains tax bill. Savvy commercial real estate investors know that there is a way to defer this tax bill by taking advantage of a transaction known as a 1031 Exchange.
What is a 1031 Exchange?
A 1031 Exchange – sometimes referred to as a “Like Kind Exchange” – is a specialized type of real estate transaction that allows an investor to defer taxes on the profitable sale of an investment property. The rules that permit this transaction are outlined in section 1031 of the Internal Revenue Code (IRC) and they state that “…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, a 1031 Exchange allows an investor to defer capital gains taxes on the profitable sale of their investment property (the Relinquished Property) as long as they reinvest the proceeds into another like kind property (the Replacement Property).
In addition to the “like kind” test, there are a handful of other exchange rules that must be met in order to qualify for full tax deferral:
- Once the relinquished property is sold, the replacement property must be identified within 45 days and the transaction must be completed within 180 days.
- The market value of the replacement property must be the same as, or greater than, the market value of the relinquished property. In addition, the amount of equity taken from the relinquished property must be the same as, or greater than, the equity in the replacement property. For example, if the relinquished property had a market value of $1M and a mortgage balance of $800,000, the replacement property must have a market value of at least $1M and it must have a mortgage balance of at least $800,000.
- The replacement property cannot be held for sale. In other words, an investor can’t buy it for the tax deferral benefits and then quickly sell it. As a general rule of thumb, the replacement property should be held for a minimum of 12-24 months.
- The relinquished property and the replacement property must both be titled in the name of the same taxpayer.
To accommodate the unique needs of each individual real estate transaction, there are four types of exchanges that an individual can utilize.
Type #1: The Simultaneous Exchange
A Simultaneous Exchange is exactly what it sounds like. In it an investor executes the sale of the relinquished property and the purchase of the replacement property on the same day. Broadly, there are three ways this could be accomplished:
- Two Party Trade: In this instance, the owners of the relinquished and replacement properties literally swap deals.
- Three Party Exchange: Instead of swapping deals directly, a three party exchange includes an “accommodating party” that acts as an intermediary between the buyer and seller to facilitate the transaction.
- With a Qualified Intermediary: A “Qualified Intermediary” is a third party who facilitates the exchange on behalf of both property owners. Their most important job is to handle the exchange of funds.
For many investors, a simultaneous exchange is difficult because they have not yet identified the Replacement Property. In such a case, they may prefer a Delayed Exchange.
Type #2: The Delayed Exchange
A Delayed Exchange – sometimes called a “Deferred Exchange” – is the most common type of 1031 Exchange. In it, there is a “delay” between the sale of the relinquished property and the purchase of the replacement property.
In a Delayed Exchange, the exchanger sells the relinquished property first. Then, they have 45 days to identify a replacement property. Once they have done so, they have 180 days to make an offer and close on the transaction. This “delay” is what makes this type attractive to many investors. It allows them time to find a suitable replacement and get the transaction closed. But, this extra time is a double-edged sword. There can be a lot of competition for the best replacement properties and it is common for investors to be rushing at the last minute to settle for any option. If they run out of time, the transaction could become taxable.
Type 3: The Reverse Exchange
A Reverse Exchange is the opposite of the Delayed Exchange. In it, the Replacement Property is identified and purchased first, then the Relinquished Property is sold.
In a Reverse Exchange, the time frame is the same, just in reverse. The Relinquished Property must be identified within 45 days and sold within 180 days. If an exchanger owns multiple properties, they need to decide which one they want to sell.
Type #4: The Construction Exchange
A Construction Exchange – also called an “Improvement Exchange” occurs when the replacement property needs some sort of renovations or improvements. In it, the relinquished property is sold, the replacement property is identified, and the proceeds are placed with a Qualified Intermediary.
While the proceeds are in escrow with the Qualified Intermediary, the improvements are made to the Replacement Property. Once complete, ownership of the Replacement Property is transferred under three conditions:
- The property must be “substantially the same” as it was before the renovations
- Construction must be completed within 180 days of the Relinquished Property sale date
- The Replacement Property’s value must be the equal to or greater than the Relinquished Property.
Which is the Best Type of Exchange?
Given the number of exchange options, it may be tempting for an investor to ask which is the best type. The answer is that there is no “best” type. Each real estate transaction is unique so it is important to find the best fit for the needs of the exchanger. Individuals should work closely with their accountants, lawyers, and real estate advisors to determine which option best fits their needs.
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.
To learn more about our real estate investing opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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