1031 Exchange Rules: Build Tax-Free Wealth
We recently provided an overview of tax reduction strategies for commercial real estate investors. The 1031 exchange was briefly covered; however, its importance to the world of commercial investing deserves a closer look. It is undoubtedly one of the most effective strategies for reducing capital gains tax liability.
A 1031 exchange allows an investor to defer paying capital gains taxes on the sale of a property if another property of equal or greater value is purchased with the proceeds. The IRS code Section 1031, outlines the 1031 exchange rules that must be followed in order to take advantage of this appealing strategy.
1031 Exchange Rules
The following rules for a 1031 exchange on commercial property provide a solid basis for navigating this tax-deferring strategy. However, we recommend that you always involve your CPA or attorney to ensure all legal steps are being followed.
Of “Like-Kind” Property
The IRS indicates that a 1031 exchange is permissible if the transaction involves a “like-kind exchange” of real estate used for investment or business.
So what is 1031 like-kind real estate?
According to the IRS, “properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.” But what does that mean? Can a multi-family unit only be exchanged for a larger apartment complex? If selling an office building, is the investor unable to purchase undeveloped land as a qualified 1031 exchange?
The definition is quite broad for qualified 1031 property exchanges. The most important rules to remember for determining like-kind property are as follows:
- Both properties must be located in the United States. Proceeds from selling a short-term rental property in Italy cannot be tax-deferred with a 1031 exchange to another property in the USA.
- Both properties must be used primarily for business or investment purposes. Proceeds from the sale of a primary residence cannot be used for a 1031 exchange.
- The replacement property must be of equal or greater value to the one being sold. If it is not, capital gains tax will be incurred on the difference (more on this later).
- Financial assets such as securities, stocks, and bonds do not qualify, as well as personal property such as equipment and collectibles. The Tax Cuts and Jobs Act of 2017 eliminated the use of these types of “property” for a 1031 exchange. Only real property (real estate) qualifies for this tax-deferred method.
If the aforementioned rules are followed, the 1031 exchange can be utilized for most any type of trade:
- Vacant land for an R&D facility
- Multi-family unit for an industrial building
- Large industrial complex for a retail strip mall
- A single-family rental for a short-term vacation rental
Replacement Property Deadlines
The strict timeline is often one of the hardest 1031 exchange rules to follow. There are two elements to the timeline requirements for the 1031 exchange deadlines.
- Identify Replacement Property – The replacement property must be identified within 45 days of selling the original property. More than one property can be identified in this step of the process.
- Purchase Replacement Property – The replacement property must be purchased within 180 days of selling the original property. In residential real estate, 180 days from start to finish may seem simple, but in commercial real estate, meeting this timeline can often be difficult.
There are three different ways to identify replacement property:
- Identify three properties regardless of their value, or
- Identify multiple properties as long as their combined value does not exceed 200% of the original property value, or
- Identify as many properties as desired as long as the identified properties are valued at 95% or more of the property being replaced
Important takeaways for 1031 exchange deadlines:
Be prepared – Before you even begin the process, take time to research the available properties in your market. Know what type of property you’re considering, the value it needs to be (of equal or greater value than the sold property), and the hurdles you may face in order to close. It is ideal to let all parties involved (broker, CPA, attorney, lender, etc.) know you will be doing a 1031 exchange before selling your original property.
Partner with Experience – An experienced and dedicated broker will be an integral part of this deal. You’ll need someone that is actively involved in the process, making sure contract deadlines are being met, communication is clear and current, and all necessary paperwork is completed.
Involve your broker from the very beginning and don’t wait until your first property has sold to begin searching for replacement properties. This only limits your leverage and puts pressure on the deal that may cause cloudy judgment.
What happens to the proceeds from the sale of the original property during those 180 days before closing on the replacement property?
The proceeds must be held by a Qualified Intermediary. This 1031 exchange rule cannot be circumnavigated – the funds must be transferred to a qualified intermediary. A qualified intermediary is a person or a company designated to hold the funds until the replacement property is purchased. The qualified intermediary should have no other attachment or relation to the parties exchanging the property.
A commercial real estate broker will be able to recommend a trusted intermediary for the exchange. While there are recent regulations that now govern this role much more closely, it’s important to find a vetted intermediary that will assist in a smooth transaction.
Types of 1031 Exchanges
A 1031 exchange is most commonly used in these 5 ways:
- Delayed exchange – This is the most common type and the simplest transaction. One property is sold and a replacement property is purchased before the 180 days expire.
- Delayed/simultaneous exchange – The replacement property is purchased at the same time the original property is sold.
- Delayed reverse exchange – The replacement property is purchased before the original property is sold.
- Delayed build-to-suit exchange – The original property is replaced with a new property built to meet the specific needs of the investor.
- Delayed/simultaneous build-to-suit exchange – The new property is built and purchased before the original property is sold.
Capital Gains Tax on Differences
If the purchased property from your 1031 exchange is less than the value of the original property, capital gains tax must be paid on the difference. For instance, if the original property was valued and sold at 1.5 million (assuming no mortgage on the property) and the replacement property was purchased for 1.4 million, there would be $100,000 of capital gains that would have to be taxed at the investor’s income tax rate.
While a 1031 exchange can certainly be used on a mortgaged property, the capital gains tax still applies to the difference of the mortgages. The mortgage for the replacement property must be the same or greater than the mortgage on the property being sold. If it ends up being less, this is considered “boot” and it is taxed as capital gains.
It’s important to note that more than one property can be purchased through a 1031 exchange; therefore, if the primary replacement property does not equal or exceed the value of the original property, an additional property can be found in order to take full advantage of the tax-deferred benefits of a 1031 exchange.
Eliminate Capital Gains Tax Permanently
As long as the 1031 exchange rules are consistently followed, there is no limit to the number of times an investor can use this powerful tax-deferring strategy. Eventually, however, if a property is sold and a 1031 exchange is not used, the capital gains tax will need to be remitted on that property.
With one exception.
If an investor holds that property (or properties) until passing away, the real estate passed on to heirs is revalued at fair market value and any deferred capital gains taxes are eliminated at that point.
1031 Exchange Rules Reviewed
- The property must be of “like-kind” real estate of equal or greater value used for business or investment purposes.
- The replacement property must be identified within 45 days and purchased within 180 days of selling the original.
- A qualified intermediary must be used for holding the funds.
- Any positive difference from the transaction, whether cash or decrease in mortgage liability, will be subject to capital gains tax rates.
- Deferred tax can continue for a lifetime and be eliminated once the property passes on to heirs.
The impact of this tax-free wealth is unprecedented. It remains one of the most powerful tools an investor can use for increasing leverage and growing a portfolio. To partner with an experienced CRE broker for 1031 exchanges, call Peak Commercial Properties. We help investors in all stages of growth to acquire commercial properties through a 1031 exchange that will provide tax-reduction strategies and build wealth for years to come.