When a real estate investor sells a property for a profit, there is good news and bad news. The good news is that they made a profit, but the bad news is that the profit can come with a big tax liability on the portion of the sale that is considered a capital gain.
Fortunately, there is a provision in the IRS tax code that allows the investor/taxpayer to defer capital gains taxes for an indefinite period of time if they “exchange” the proceeds of the sale into a new property that is considered “like-kind.” This type of transaction is known as a “1031 Exchange” or a “Like-Kind Exchange.”
In order to understand what a “like-kind” property is, it is first necessary to define how a gain is calculated on a tax return and how a 1031 Exchange is used to defer taxes on it.
What is a Gain?
The difference between a property’s “tax basis” and the sales price represents a “capital gain” and it is taxable. The calculation of tax basis can be complicated and it should be completed by a CPA, but it is generally calculated as the property’s purchase price plus the cost of any improvements made during the holding period, minus depreciation taken.
Example of Taxable Gain
For example, assume that a property was purchased for $1,000,000 and $250,000 was invested in improvements over the holding period. Also assume that $150,000 was taken in depreciation. In such a scenario, the tax basis is calculated as $1,100,000 (($1,000,000 + $250,000)-$150,000). If the property was sold for $2,000,000, the taxable “gain” is $900,000.
Types of Capital Gains Taxes
There are two types of capital gains taxes: short term and long term. Short term capital gains taxes must be paid for properties held less than 12 months. Under IRS rules, short term gains are categorized as “ordinary income” and the tax rate depends on the individual’s income tax bracket, which can range from 10% to 37%. Long term capital gains taxes must be paid for properties held more than 12 months. They are calculated based on the taxpayer’s income and filing status and range from 0% – 20%.
To defer capital gains taxes, real estate investors can execute a 1031 Exchange.
What is a 1031 Exchange?
A 1031 Exchange is a specialized type of real estate transaction that allows a real estate investor to defer capital gains taxes on the profitable sale of an investment property.
The rules that sanction this transaction are described in section 1031 of the Internal Revenue Code (IRC), which 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…”
Naturally, this description begs the question, “what is real property of like-kind?”
What is Like-Kind Property?
To understand the IRS definition of like-kind property, it is first necessary to understand two terms: relinquished property and replacement property. The relinquished property is the property that is sold in a 1031 Exchange, and the replacement property is the property that is purchased with funds from the sale.
With these terms known, IRS rules state that: “Both the relinquished property and replacement property must be similar enough to qualify as “like-kind,” which is defined as “property of the same nature, character, or class.”
The quality or grade of the properties does not matter. Most real estate is like-kind to other real estate with one exception: property within the United States is not like-kind to property outside of the United States.
For example, an apartment building in California would be considered like-kind to an office building in Florida. But, vacant land in Texas is not like-kind to a rental property in Mexico.
What Does Not Qualify as Like-Kind Property?
Aside from property outside the United States, it should also be noted that IRS Code Section 1031 specifically excludes certain types of properties as like-kind.
Like-Kind Property Restrictions
Real property and personal property can both qualify as like-kind property, but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.
In addition, the following property types are not considered like-kind to anything and are specifically excluded from a 1031 Exchange:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
Like-Kind 1031 Exchange Examples
To illustrate how a like-kind exchange works in practice, there are several 1031 Exchange examples below that cover the types of scenarios that a real estate investor could potentially encounter.
1. Like-Kind 1031 Exchange With Boot
In a 1031 Exchange, “boot” is defined as the fair market value of cash or “other property” received in a 1031 Exchange. If received, it is taxable.
For example, suppose a real estate investor sold raw land for $1,000,000 and used $800,000 of the proceeds to purchase a shopping center. The $200,000 difference is considered “boot.” Depending on how long the property is held, it could be subject to short or long term capital gains taxes.
2. Like-Kind 1031 Exchange with Debt
Realistically, most commercial real estate properties have some sort of debt associated with them. Under Internal Revenue Service Rules, the value of the relinquished property and the equity in it must be the same as or greater than the replacement property. If it isn’t, the difference could be considered boot and it is taxable.
For example, suppose that an exchanger sold an office building for $1,000,000. At the time of sale, the amount of debt outstanding was $750,000, which means that there is $250,000 in equity. In order to avoid receiving boot, the new property must have a value of at least $1,000,000 and the debt must be at least $750,000.
3. Reverse Exchange
In a reverse exchange, the 1031 Exchange process happens in reverse. This means that the replacement property is identified and purchased first and the relinquished property is sold second. Often, this happens when a suitable replacement property is discovered quickly.
For example, suppose that a real estate investor is planning to sell a warehouse and they plan to use the money to purchase an apartment building. But, they find the apartment building much faster than they thought, so they place it under contract and complete the transaction. Then, they put the warehouse up for sale.
4. Partial Exchange
A partial exchange is similar to a like-kind exchange with boot. In a partial exchange, the full proceeds of the sale are not invested into the replacement property.
For example, suppose a shopping center was sold for $500,000 cash, but only $450,000 was used to purchase the replacement property. Since this amount is less than the sales proceeds, it is considered to be a “partial” exchange and the difference is boot and taxable.
5. Like-Kind 1031 Exchange with Multiple Properties
1031 Exchange rules don’t mandate that properties must be exchanged 1:1. It is possible to 1031 exchange one property for multiple properties as long as the following rules are met:
- Rule of Three: The exchanger can identify up to 3 like-kind replacement properties
- 200% Rule: The exchanger can identify unlimited properties as long as their cumulative value does not exceed 200% of the market value of the relinquished property.
- 95% Rule: The exchanger can identify more than three properties whose value exceeds 200%, so long as they acquire 95% of the value of the replacement properties.
For example, suppose a real estate investor sold a medical office building for $5,000,000. They could use these proceeds to buy a retail property, office property, and multifamily property, so long as the total does not exceed 200% of the value of the relinquished property.
Like-Kind Exchanges with Delaware Statutory Trusts (DSTs)
One of the major challenges facing 1031 Exchangers is finding a suitable replacement property. 1031 Exchanges are very popular and the competition for the best replacement properties can be intense. One possible solution to this issue is to invest sales proceeds in a Delaware Statutory Trust or “DST.”
A DST is a specialized type of company formed specifically for the purpose of acquiring a commercial real estate property. Instead of purchasing a replacement property outright, 1031 Exchange investors can purchase shares in a DST and use them as the replacement property instead. This provides real estate investors with fractional ownership of an institutional quality asset and all of the benefits of ownership without the hassle of actually managing the property.
Investors interested in a DST purchase should work closely with their CPA and investment facilitator to ensure that all rules are met to qualify for full tax deferral.
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 properties 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 investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
