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Commercial real estate investing includes multiple strategies to maximize returns and minimize taxes, and one of the most powerful tools available to investors is the 1031 exchange. The term is named for Section 1031 of the U.S. Internal Revenue Code and enables investors to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into another property. If you are considering a 1031 exchange or simply want to learn more about this tax strategy, then let’s explore how a 1031 exchange works, its benefits, rules, and how to execute it as part of your investment strategy.
At its core, a 1031 exchange – also known as a “like-kind exchange” – involves swapping one investment property for another. Traditionally, when you sell an investment property, you may be subject to capital gains taxes. However, if your swap satisfies the requirements of a 1031 exchange, you can owe no or minimal taxes at the time of the exchange. While most exchanges of commercial real estate are not direct swaps, the basic concept holds. That is, by reinvesting the sale proceeds of your existing property into a new property, an investor can defer capital gains taxes that would otherwise be due upon the sale. Importantly, a 1031 exchange doesn’t erase taxes. Rather, you can defer taxes to a future date, which can provide you with financial benefits. You can repeat this process until you eventually sell a property for cash. In this example, while you may generate profit with each property, you could keep delaying otherwise taxable gains until the final sale. Therefore, rather than pay tax each time you exit a property, ideally you pay capital gains tax once.
The ability to defer taxes on the sale of an investment property is the most significant, practical advantage of a 1031 exchange. Rather than pay taxes upon sale of a like-kind exchange, an investor can allow the investment to compound over time without tax leakage. Therefore, an investor can reinvest the proceeds from the asset sale into another property. This tax deferral process is similar to an IRA or 401k, which allows investors to buy and sell securities and then defer taxes until withdrawing the proceeds in retirement.
Reinvestment into a new property enables an investor to generate relatively higher returns compared to paying taxes each time an investor sells a property, which would result in having fewer proceeds to reinvest. Further, since an investor can engage in a “like-kind” exchange, an investor can diversify their portfolio to different geographic location or properties, which can provide not only flexibility and risk mitigation but also portfolio growth and stability.
Before engaging in a 1031 exchange, it’s important to understand the key rules from the IRS.
First, to qualify for a “like-kind” exchange, the property being sold and the new property being acquired must be used for business or investment purposes. Therefore, a primary residence wouldn’t qualify, unless it’s a rental property that is held for an investment purpose. Second, the timing of the exchange is critical for investors. Investors must formally identify a replacement property within 45 days from the sale of the existing property.
Timing plays a critical role in the execution of a 1031 exchange, governed by deadlines imposed by the IRS. Ideally, you would exchange one property for a similar property owned by another investor. However, this traditional transaction can be challenging to identify. Therefore, most 1031 exchanges are delayed exchanges. A delayed exchange typically involved a neutral, third-party intermediary (Qualified Intermediary) who holds the cash proceeds for you after you sell your existing real estate property. Then, the intermediary purchases the new investment property on your behalf. The intermediary also can coordinate the transfer of title and funds to help complete the exchange.
In a delayed exchange, you have 45 days from the sale of your existing property to identify the new property that you want to acquire. You have 180 days from the sale date of your first property to close on the acquisition of the new property. Notably, the identification period and exchange period run concurrently, so you have 180 days both to identify and exchange the existing and new properties.
You must report a 1031 Exchange to the IRS on Form 8824.
Executing a successful 1031 exchange starts with understanding the rules. There is required preparation, strategic planning, and financial analysis that any smart investor should undertake before embarking on a 1031 exchange.
You will want an experienced team to be engaged throughout the process. This could include a real estate lawyer, accountant, tax advisor, real estate broker, acquisitions team and other professionals who can evaluate a like-kind property. Your team can also help analyze 1031 exchange rules, including with respect to depreciation recapture, for example. During the identification period, make sure to evaluate multiple, potential properties to provide maximum flexibility. You and your team should ensure you follow all rules and regulations and work with a reputable intermediary.
Investors should regularly evaluate their portfolio to identify potential opportunities for a 1031 exchange. This strategy should comport with your long-term investment goals while focusing on long-term growth, tax efficiency, upgrading to new assets, and property diversification.
A 1031 exchange is an excellent tool for commercial real estate investors and offers the ability to defer capital gains taxes while powering portfolio growth and diversification. The ability to reinvest sale proceeds without an immediate tax burden enables investors to leverage compounding and increase investment returns. By understanding the rules and regulations of 1031 exchanges, investors can defer taxes, access new properties and geographies, increase returns, and achieve continual portfolio growth in an efficient way.
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