1031 exchanges are a helpful tax deferment strategy that every commercial real estate investor needs to know about. When an investor sells a property in profit, any gains are taxable under the capital gains tax, either 0%, 15%, or 20%, depending on a filer’s annual income.
For most commercial real estate entities managing several properties, taxable income will likely exceed the limits on the third bracket, meaning that 20% of the gains go to the federal government.
If a property sells for $1,000,000, then $200,000 of the total must go toward taxes unless the investor plans to immediately reinvest those profits into another property or group of properties.
Introducing the 1031 Exchange
If this is indeed the plan, then the investor can file what is known as a 1031 exchange for commercial real estate or a “like-kind” exchange. This filing, if approved, allows the investor to defer capital gains on the sale of the relinquished property if they use the proceeds to invest in a replacement property or properties so long as they are of “like-kind.”
What Are 1031 Exchange Rules?
Certain qualifications need to be met for the IRS to approve a 1031 exchange with full tax benefits. If some of the following conditions are not met, it doesn’t disqualify the transfer but could impact how much of the tax liability gets deferred.
Let’s explore the rules governing 1031 exchanges in more detail:
Are The Properties Like-Kind?
The replacement property (or properties) must be of the “same nature or character” as the relinquished property. But this doesn’t mean that the new properties have to have the same functional purpose as the old property. “Like-kind” here doesn’t mean the same property type—a multipurpose skyscraper in a city can be exchanged for an office park complex in the suburbs.
What makes a property “like-kind” is its use to the investor. For example, investors cannot replace their commercial property with multiple single-family residential properties. The commercial property was held for productive use as a commercial investment. Using the proceeds to invest in residential investment properties would break the “like-kind” rule.
The Time Between the Sale and Purchasing Of New Properties
The time frame between the sale of the relinquished property and purchasing replacement properties is intentionally narrow, making the search and acquisition of replacement properties highly competitive.
Investors must identify potential replacement properties within 45 days of the sale of the relinquished property. After this, they have 180 days to complete the transfer for the capital gains tax deferral to remain in place.
The Value Of The Properties Must Be The Same. Differences Are Taxable.
Both the market value and equity of the relinquished property and any replacement properties must be the same. If the replacement properties have less value than the relinquished property, then the investor still must pay capital gains on the difference.
For example, if the relinquished property is valued at 10 million and has 4 million worth of debt, then any replacement properties must amount to 10 million and have 4 million worth of debt.
There Can Be No Boot For Full Tax Deferment
“Boot” is jargon for any property or asset that is not like-kind. The boot could be non-like kind property, like personal residences, or it can be a completely different asset like shares in a company, cash, or some other asset. Using boot in a 1031 exchange doesn’t prevent the exchange from happening, but it could compromise the tax deferment or limit it.
Replacement Property Cannot Be Held For Sale
The replacement property cannot be immediately sold after investors were granted a 1031 exchange. Otherwise, they must pay capital gains taxes on the sale of the new property, making the whole exchange convoluted.
Generally, investors will hold replacement properties for 12-24 months before selling or filling another 1031 exchange. Theoretically, an investor can keep reinvesting and defer taxes for as long as they wish.
The Taxpaying Entity Must Be The Same For All Properties
The taxpaying entity, whether an individual or a business entity, must be the same for the relinquished and replacement properties.
Ready To Defer Capital Gains Taxes On Your Investments?
There are some exceptions to the rules listed above. In reality, there are four types of 1031 exchanges that investors might qualify for.
- delayed exchange/deferred exchange
- reverse exchange
- simultaneous exchange
- construction exchange
There may be ways to defer tax liabilities and grow your wealth using the same strategy that made Warren Buffet his billions!
About the Author:
Jenn Walker is a freelance writer, blogger, dog-enthusiast, and avid beach goer operating out of Southern New Jersey.