Savvy commercial real estate investors utilize the 1031 Exchange strategy to diversify their holdings and expand their portfolios. Furthermore, they can also increase their net worth faster. So, if an investor wants to sell their commercial assets, they must seek the popular tool of the 1031 exchange to maximize their profits and avoid paying capital gains taxes.
In this blog, we will delve into the concept of the 1031 exchange and the details of this tax-deferring transaction.
What is a 1031 exchange?
Typically when an investor sells an investment property, they have to pay significant federal or state capital gains taxes at about 15-20% of the profit and capital gains that they make from the sale.
Furthermore, accumulated depreciation recapture is taxed at a federal rate of about 25%.
As a result, it reduces their returns and decreases their ability to purchase and invest in more income-producing assets.
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code.
It allows an investor to defer paying federal and state capital gains taxes and recaptured depreciation on the sale of an investment property. However, the investor must reinvest the sale proceeds in real properties or property of equal or greater value within a certain time frame.
What is a like-kind exchange?
The 1031 exchange is also known as a like-kind exchange.
Section 1031 of the Internal Revenue Code defines the process of like-kind exchange as:
“ When you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or like-kind.”
This strategy of deferred exchanges has been in existence in the tax code since 1921.
The Internal Revenue Service considers exchange properties like-kind on the basis of a few factors.
These include the likeness of physical properties, rights of the parties, the character of title conveyed, and period or duration of interests.
Therefore, commercial real estate investors can exchange an apartment building for a larger multi-family apartment project, or even for office property.
However, the definition of a like-kind property has undergone several tweaks since 1921. For instance, the Tax Cuts and Jobs Act of 2017 excluded personal and intangible property from tax deferral exchange benefits.
Also, the Act created the Opportunity Zones incentive that enables tax-deferred investments in urban and rural areas with low incomes.
Furthermore, the Biden administration has proposed reducing 1031 exchange referral limits to $500,000 per year and $1 million for couples filing jointly.
Read Lilypads’ blog on Opportunity Zone investments here.
How does a 1031 exchange work?
1031 exchange rules and timings
- An investor can only use the properties that they use for business or investment purposes for the 1031 exchange. Therefore, in 1031 exchange primary residence cannot be used for replacement purposes. But, they can relinquish their single-family rental property for commercial rental property.
- The replacement investment property in a 1031 exchange real estate should be of equal or greater value. So, there are three rules that define identification.
1. The three-property rule:
The investors can identify no more than three properties irrespective of their market value.
2. The 95% rule:
However, the investors can identify unlimited properties only if their combined acquisition value is not less than 95% of the original property.
3. The 200% rule:
Moreover, the investors should ensure that the combined value of the properties does not exceed 200% of the replaced property.
- Next, the investor must identify a replacement property within 45 days of selling the previous property.
- Furthermore, the investor should close the purchase of the replacement property within 180 days from the date on which they sold the current property.
Also, the investors must remember that 180 days are not the same as 6 months. The IRS counts each individual day, weekend, and holiday within the 180-day time frame.
- The real estate properties with an existing mortgage also qualify for 1031 exchanges. The amount of mortgage on the replacement property must be the same or greater than the mortgage on the original property.
And, any non-like kind property is treated as boot. It is in the form of mortgage debt, cash or personal property received in exchange. So if an investor receives a boot when a property is sold, the boot that they receive becomes taxable.
- If an investor wants to sell rental properties, they have to exchange them for another rental. So, they cannot exchange their rental property to buy a vacation home.
The role of a Qualified Intermediary in a 1031 Exchange
Active real estate investors who perform 1031 exchanges when they sell their properties and buy replacements can defer paying capital gains tax. Furthermore, they can also entirely eliminate paying taxes through diligent estate planning.
As a result, investors can enjoy more liquidity and subsequently re-invest their capital gains to scale their real estate portfolios.
But, if the investor spends the money or moves it into their account, they will incur tax penalties from the IRS. Moreover, the tax benefits of the 1031 exchange will fall null and void.
Therefore, the investors require the assistance of a Qualified Intermediary (QI).
A qualified intermediary is an individual or a company that agrees to facilitate the 1031 exchange by holding the escrow exchange funds.
Hence, the proceeds from the sale must be transferred to a Qualified Intermediary rather than the seller of the property.
And, the qualified intermediary retains the power of transferring the amount to the seller of the replacement property.
Depreciation in 1031 Exchange
Depreciation plays an important role in 1031 exchanges. It is a tax benefit that a property owner can claim to recover the cost of a property over a predetermined period recognizing the effects of wear and tear.
During the sale of a property, Its capital gains tax is calculated on the basis of the assets net adjusted basis. The net adjusted basis in turn reflects the asset’s initial purchase price Plus improvement costs and other related costs minus depreciation.
1. Replacement property has a higher value than the relinquished property:
In such a ‘trade-up case, the investor can factor in depreciation recapture on the difference between the sale of the old property and the purchase price of the new property. So, the depreciation will be included in the taxable income from the sale of the property. And, the date, method, and life of depreciation will be the date when the investor acquires the replacement property.
2. Replacement property has a lower value than the relinquished property:
This scenario refers to ‘buy-down’. Hence the depreciation basis of the new property will be similar to that of the old property. So the investor can continue their depreciation schedule like the old property.
3. Replacement property has a similar value to the relinquished property:
Here, the depreciation schedule remains the same as it was for the old property. Therefore the investor can continue their depreciation calculations on the basis of the now-relinquished property.
Different types of 1031 exchanges
There are four primary types of real estate exchanges varying in their timing, Procedures, and requirements. include:
1. Simultaneous Exchanges:
A simultaneous 1031 exchange takes place when the investor sells their Old property and acquires a replacement on the same day.
2. Delayed Exchanges:
Delayed exchanges are the most common type of 1031 exchanges. Here the investor can conduct a delayed exchange, whereby they have 45 days to identify their replacement property and 180 days to close their acquisition.
3. Build-to-suit Exchanges:
A Build-to-suit exchange is also referred to as a construction or improvement exchange. It allows the replacement property to be renovated or newly built within 180 days before the actual exchange takes place.
4. Reverse 1031 Exchange:
A reverse exchange occurs when an investor identifies and purchases replacement property even before selling their current investment property.
The Lilypads Bottomline
1031 exchange in real estate can be beneficial for investors if they follow all of its rules to the letter. If the investor can associate with a Qualified Intermediary to handle their exchanges and refrain from using their personal property while maintaining the time frame of the exchange-they can defer paying capital gains taxes indefinitely or permanently.
As an investor, 1031 exchanges can help in portfolio diversification with a wide variety of assets that provide better-estimated returns.
Furthermore, when the real estate investor passes away, the property is passed on to their heir after it is stepped up to its fair market value. This entirely eliminates any deferred capital gains tax liability.
Therefore, the 1031 Exchange provides a great deal of flexibility to investors. However, the process can be complex for newer and ordinary investors. Hence it is wise to seek professional assistance before starting with a 1031 exchange.