Buying and selling property and building a robust real estate portfolio can be an exciting experience for both parties, especially when profit, or gain, is part of the equation. Gain happens when property appreciates in value or when the seller takes advantage of depreciation deductions for tax purposes. In either case, it’s important to understand tax ramifications of your real estate transactions and how to make the most of your investment dollars. A 1031 Exchange may be a great option for maximizing your investment and getting the most out of your next commercial real estate investment.
What is a 1031 Exchange?
Essentially, it’s a swap.
“Whenever you sell business or investment property 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 similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.”
IRS.gov, Like-Kind Exchanges Under IRC Code Section 1031
Named for the Internal Revenue Code Section it refers to, a 1031 Exchange is a tax deferred exchange, and allows an exemption to the capital gains tax. In other words, when you sell your business or investment property and replace it with a different business or investment property, you can defer payment on the capital gains that would ordinarily be required. There’s no limit to the number of times a 1031 can be employed.
5 Things You Need to Know About a 1031 Exchange
All old and new property must be vacant. Undeveloped lots, vacated businesses or uninhabited apartment complexes qualify for a 1031.
You can’t actually control the proceeds from the sale; however, a licensed commercial real estate attorney can help you execute a 1031.
The clock is ticking! You only have 45 days from the date of closing to identify your next investment and 180 days to close on one of your identified properties.
The titleholder on your old property must be the same as the titleholder on the new property.
To avoid paying capital gain taxes, all proceeds from the sale must be applied to your new property investment.
6 Interesting Facts About a 1031 Exchange
It’s generally not for personal use: a 1031 is typically for business and investment properties only. The tax code excludes some property, even if it’s used in trade or for investment, for example stocks, bonds, notes and securities are excluded from a 1031 exchange.
Naturally, there are exceptions to the personal use rule: while a 1031 Exchange applies primarily to real estate, some personal property, such as fine art, may qualify.
The definition of “like-kind” is loose: you can exchange an urban apartment complex for an undeveloped oceanfront property.
You can “delay” the exchange: while “exchange” implies an even swap, in reality, the odds of finding a buyer who happens to have what you want, and who also wants what you’re selling, are pretty slim. In a delayed exchange, you need a third party who holds the “proceeds” and then uses it to “buy” the replacement property on your behalf. A qualified attorney can help you better understand the benefits and limits of delaying a 1031 Exchange.
You can increase and diversify your portfolio: one property can be exchanged for two, three or even five as long as you maintain your existing value, equity and mortgage. Many 1031 Exchanges even cross state lines, allowing you to increase and diversify your holdings.
Consider mortgages, debt and liability: even if you don’t receive any cash for the exchange, but your liability goes down, the IRS will consider this a gain and you will be taxed.
Before you pick up the phone, though, have the information of all relevant parties at hand: names, addresses, phone numbers and file numbers. Be prepared to answer questions about the property you plan on relinquishing to the third party as well as your replacement property (your attorney may act as your third party). A strong real estate attorney will want to understand your goals and objectives to better help you meet them. Some additional questions you should be prepared to address include:
What is being “sold”?
When did you purchase the property?
How much did it cost?
How is it vested?
How did you use the property?
What is the value, mortgage and equity on the property?