Often overlooked, a 1031 exchange is considered one of the best-kept secrets in the Internal Revenue Code as it can offer a real estate investor significant tax advantages. It is a strategy that all Commercial Real Estate (CRE) investors should take advantage of.
What is a 1031 Exchange?
A properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer associated taxes.
IRC Section 1031 (a)(1) states: "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."
What are the Benefits of a 1031 Exchange?
The IRS Code, Section 1031, allows a property owner the ability to exchange their income, investment or business property for a replacement “like-kind” property in order to defer ordinary income, depreciation recapture and/or capital gain taxes.
Used correctly, 1031 Exchanges are a great wealth building tool. CRE investors who use this strategy benefit greatly from net-worth increases, and consequently, increased cash-flow, thus it is one of the most powerful tactics available.
By deferring the taxes, the investor has increased purchasing power and is able to redeploy their capital on investments that are more aligned with their business strategy.
1031 Exchange - Replacement Properties:
As used in IRC 1031(a), the words "like-kind" mean similar in nature or character, notwithstanding differences in grade or quality.
Examples of qualified 1031 like-kind properties and like-kind exchanges:
What are the Regulations of a 1031 Exchange?
Timing is significant. There is a 180-day window (after the sale of the relinquished property) during which the seller involved much close on the purchase of the replacement property in order for the Exchange to be valid. The replacement properties must be identified as part of the exchange no more than 45 days from the time the seller’s property has closed escrow. The closing of the replacement property must be complete within 180-days of the transfer of title. This is where a knowledgeable, experienced Real Estate Team factors in. The Agent should have viable exchange properties ready for the seller’s consideration even before the closing on the property being sold.
The total purchase price of the replacement property should be equal to or greater than the net sales price of the relinquished property. All of the equity from the transaction must be used to acquire the target property. If the sales price is less, a tax will be applied to the difference. Likewise, the net equity in the replacement property must be equal to or great than the net equity in the sold property or tax will be added for the amount of decrease.
Simply selling one property and buying another disqualifies the exchange. To be valid, the transaction must go through a qualified intermediary who can facilitate such exchanges. The intermediary should be an independent organization that will handle the funds throughout the exchange process and is able to fill out all appropriate tax forms related to the process. A real estate agent may serve as a QI under certain circumstances but it important to check with legal counsel prior to beginning the process.
The sale of a property and subsequent purchase of another property doesn’t work; it must be a 1031 Exchange.
Formats for a 1031 Exchange:
What are the Negatives of a 1031 Exchange?
The regulations established by the IRS essentially reward taxpayers for investing back into the economy. Not adhering strictly to the rules could cost the investor certain tax penalties.
Not surprisingly, the roadblocks in attempting to comply with 1031 Guidelines can be challenging. For example, though it may be fairly easy to locate a like-kind property within the first 45 days, it may be very difficult to actually close within the 180-day limit if the due-diligence turns up unexpected problems. If more than one property is to be purchased, the time restraints may be even more difficult to adhere to. Generally speaking, the IRS does not allow extensions.
Because of the exchange, the replacement property’s tax bases may be reduced (the purchase price less the gain deferred.) Thus, if the property is ever sold outright, the deferred gain will be taxed.
Just as the applicable taxes are deferred, the losses will also be deferred.
Selling at a future date could mean paying greater capital gain taxes should the rates increase while the property is held. Of course, the opposite could be true.
A 1031 Exchange is not eliminating the tax obligation, it is only deferring it. If used correctly, exchange transactions could significantly increase the value of the investor’s net holdings, thus, when the properties are finally sold, the full tax obligation (which could be significant) would be recognized.
Simple Example of a 1031 Exchange?
· An investor sells a commercial property and has a $300,000 capital gain.
· He incurs a tax liability of approximately $75,000 in depreciation recapture, federal and state capital gain taxes.
· Only $225,000 remains to be reinvested in another property.
· The same investor choses to do a 1031 Exchange.
· He is able to reinvest the entire $300,000 toward the purchase of an $800,000 commercial property by deferring the tax obligation under the 1031 guidelines.
Any professional(s) involved with advising or counseling real estate investors need to know about tax-deferred 1031exchanges, including Realtors, lawyers, accountants, financial planners, tax advisors, escrow and closing agents and lenders.
We at McCoy Wright Realty are knowledgeable on 1031 Exchanges and can help guide you through the real estate portion of the transaction; however, we advise that you should also secure the services of qualified Legal Counsel and a Tax Professional.