Commercial real estate owners and investors often undergo acquisitions and dispositions to better align their CRE portfolios with business or financial goals. But these transactions can come with costly taxes.
One way to reduce your tax burden when it comes time to sell or replace a property is by leveraging a 1031 tax deferred exchange.
Most commonly used among CRE investors, 1031 exchanges are a lucrative disposition strategy that enables owners to defer capital gains. Continue reading to learn more about 1031 exchanges and how they could benefit you.
What Are 1031 Exchanges?
A Section 1031 tax deferred exchange, also known as a “like-kind exchange,” is a tax break made available by the IRS to owners of U.S. real estate. It allows owners to defer the capital gains tax that would otherwise be owed on the sale of the property.
Whenever you sell commercial or investment real estate and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in a similar property as part of a qualifying like-kind exchange. Gains deferred in a like-kind exchange under IRC Section 1031 are tax-deferred, but they are not tax-free.
1031 exchanges increase your buying power, and are most commonly seen among high-net-worth CRE investors, but can also be used by corporate owner occupants.
When to Consider a 1031 Exchange
You should consider a 1031 exchange when there is an opportunity to sell a property high and buy another one low. The 1031 exchange enables you to roll over the proceeds from the sale, ultimately deferring the taxes.
Keep in mind, though, that a 1031 exchange only works in your favor when you are in a position to both sell one asset and acquire another within a finite time frame. There also must be two properties involved or you do not qualify for the tax break.
Moreover, the provisions of the 1031 exchange apply to both business properties and investment properties. And they apply only for like-kind assets. That is, both properties must be of the same nature, character, or class. Quality or grade does not matter.
9 Steps to a Successful 1031 Exchange
The 1031 exchange process often involves a series of steps to ensure that all parties are aligned with the guidelines and deadlines of the exchange.
1. Evaluate. Evaluate your CRE portfolio and identify the property or properties that are ready to be sold and replaced. In most instances, the property will be an unsupportive asset—one that no longer positively impacts your goals.
2. Market. Identify the appropriate target buyers for your property and leverage marketing tactics to sell the real estate.
3. Exchange. Transfer the capital gains to a qualified intermediary, such as an exchange firm or corporation.
4. Identify. Per 1031 exchange guidelines, you must identify a like-kind property within 45 days. The following supplemental rules should also be considered when selecting a property or properties for the exchange.
- The three-property rule allows you to identify three properties as potential purchases regardless of their market value.
- The 200% rule allows you to identify unlimited replacement properties as long as their cumulative value doesn’t exceed 200% of the value of the property sold.
- The 95% rule allows you to identify as many properties as you like as long as you acquire properties valued at 95% of their total or more.
5. Notify. Send a letter of intent (LOI), outlining the full terms of your proposed transaction, to your intermediary.
6. Negotiate. Negotiate with the seller of the like-kind property to arrive at fair terms.
7. Agree. Following negotiations, confirm the sale price for the like-kind property.
8. Wire. Request that the intermediary wire the capital gains to the titleholder or title company. Note: The sale of the exchanged property must close within 180 days.
9. Complete. Fill out IRS Form 8824 to defer the associated taxes.
Benefits of 1031 Exchanges
The primary benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing up more capital for investment in the replacement property.
Another benefit is that you reset or defer your depreciation recapture. You avoid the large increase in taxable income that depreciation recapture would cause later on. This saves you as much as 25% on the depreciation of your property.
With 1031 exchanges, you also avoid paying state taxes. Some states require either the buyer or the seller to pay state income taxes, known as state mandatory withholding, when a property is sold. However, properties transferred in a 1031 exchange can be exempt.
Learn More Disposition Strategies for Owned CRE
Corporate real estate optimization is fundamental to achieving your business goals and responding to new challenges. Learn more ways to address unsupportive assets in your CRE portfolio by downloading our free guide, Portfolio Optimization: The Essential Corporate Real Estate Guide.