Valuable commercial property can present their owners with a dilemma, especially in a hot real estate market.
The owners may very well want to sell, but are afraid of getting clobbered with a big capital gains tax bill given how much more the office building or strip mall is worth now compared to when they bought it years ago.
However, savvy real estate investors and business people know a little trick to defer paying capital gains taxes, and best of all, it's perfectly legal. It's called a 1031 exchange, in reference to Section 1031 of the Internal Revenue Service code.
If you're a real estate investor or business owner looking to sell a commercial property, it can be a helpful rule to know.
What Is a 1031 Exchange?
The IRS code's Section 1031 makes it possible for an investor to defer paying capital gains taxes on an investment property upon its sale -- as long as another, "like kind" property is bought with the profit from the sale of the investment property.
This strategy can reduce your overall tax burden.
It is sometimes referred to as a Starker exchange, because the first person in a tax case that resulted in it being allowed was named Starker.
In a 1031 exchange, a property owner can swap an investment property for another of a like-kind. But for this to work, the owner whose property you want to acquire will have to want to buy your property in exchange. This is why there are essentially three ways to do a 1031 exchange: A delayed, three-party, or Starker exchange.
In a delayed exchange, a facilitator holds the cash after you sell your property, and uses it to buy its replacement for you. The exchange is then treated by the IRS as a swap.
Normally, when you sell an investment property, you have to pay capital gains tax. Sometimes, because of this, selling a property that has been a burden or bad investment can cost you more than what you make by selling it.
But if you own a rental property or other property that has gained in value from its original purchase price, you could make money using a 1031 strategy. To use the tax deferred strategy effectively, you have to buy a property of similar value to one you sell. In this way, you'll avoid at least temporarily having to pay capital gains tax on the sale.
You will, if you're an investor, cash out at some point and pay taxes. But, meanwhile, you can trade properties without causing a sudden tax obligation. The one sticking point of a 1031 is that both the purchase price and the new loan amount has to be the same or higher on the replacement property.
For instance, if you sold a property for $1 million that had a $650,000 mortgage, you'd have to buy a property for $1 million or more with $650,000 or more in leverage.
Essentially, the steps for a 1031 exchange are:
- Sell an investment property;
- hand your capital gains to a qualified intermediary;
- identify a like-kind property with 45 days;
- negotiate with the seller of the like-kind property;
- agree on a sales price;
- have your intermediary wire the capital gains to the title holder or the title company;
- fill out the IRS form.
If you own a business, and you're thinking of investing in another one, you might also want to consider a 1031 Exchange.
Businesses usually include personal property like tangible and intangible assets, goodwill and real property (like real estate). Under a 1031 Exchange, real and personal property can be exchanged for like-kind properties. Goodwill cannot.
But a business could exchange commercial property for residential property, or vice-versa. Non-depreciable properties are not considered like-kind. Meaning a depreciable asset cannot be exchanged for something non-depreciable. Meaning it is easiest to sell and purchase a similar business with similar assets. As an example, two restaurants with similar properties and equipment would benefit likely from a 1031 exchange.
Examples of 1031 Exchanges
A couple purchases a small apartment building in California 10 years ago for $1.5 million. The couple puts $500,000 of their own money down, and takes out a mortgage for the $1 million.
After a number of years, the couple's adjusted basis in the property may show the purchase price, the acquisition cost (such as title insurance) of $10,000, plus capital improvements (such as a new roof) of $65,000, minus the depreciation over the time they've owned the property of $400,000. Without taking into account deferred capital gains, the property's adjusted tax basis at sale would be: $1.175 million.
The couple decides to sell their property. They think they could price it at $2.85 million, less closing costs on relinquished property of about $50,000, making the net selling price $2.8 million. Subtract from that the adjusted tax basis of $1.175 million, and the realized gain on the sale would be $1.625 million.
But that is different from the net cash received. For that, take the sale price of $2.85 million; subtract about $800,000 paid down on the mortgage, and the closing costs on relinquished property, and the net cash received at the sale would be $2 million.
Now, the couple needed to estimate their tax liability from the sale. Assuming a realized gain of $1.625 million on the sale, they'd have to estimate their Capital Gains tax on the sale of about 20%, or $245,000; the federal tax on Depreciation Recapture of 25%, or $100,000; the Affordable Care Act tax surtax of 3.8%, or $61,750; and the California State Capital Gains Tax of 12.3%, or $199,875, resulting in an effective tax rate of 37.3%, or $606,625.
By using a 1031 Exchange strategy, the couple may be able to defer their 37.3% liability in taxes and keep all their profit from the sale. With the 1031 Exchange, they have $2 million in equity available to reinvest after the sale, instead of $1,393,375 ($2 million minus the taxes paid of $606,625).
To defer all of their property taxes, the Replacement Property must have a purchase price and mortgage balance equal to or greater than the Relinquished Property being sold. Investors aren't required to invest all of their sale proceeds into the Replacement Property, but then they are doing what is called a "Partial Exchange," and what is not reinvested is referred to as "Boot," which is subject to taxes.
Essentially, any investment property other than your primary residence can qualify for an exchange. The IRS considers any investment property as "like kind." Meaning, they don't even have to be the same type. Raw land can be exchanged for an office building, and an exchange can be conducted between any two properties in the U.S., or even multiple properties, or Replacement Property Interests - in which the investor owns a proportionate share of property along with others.
You are a real estate investor, and you bought a residential investment property two years ago for $50,000. You own it outright. You get it appraised and find its current worth is $100,000. If sold, the property would have a capital gain of $50,000, and about $5,000 in capital gains tax.
You decide to sell your property and purchase a larger property with your capital gains, deferring the capital gains tax on the sale, depreciation recapture, and maybe state taxes, using a 1031 Exchange.
First, you try to sell your property for $100,000 using a real estate agent, knowing it could result in $50,000 in capital gains from your initial purchase price. When the title is transferred, the clock starts running on the 45-day identification process.
You find a qualified intermediary, who holds your capital gains on the sale almost like an escrow account. Within the 45-day period, you send the qualified intermediary a letter listing the properties you have identified for a 1031 Exchange. Up to three properties can be on the list, but only properties on that list can be used in a 1031 Exchange.
Once your agent finds a like-kind property within those 45 days for $150,000, you'll have six months from the sale to close on the like property. Once the seller agrees to sell the property to you for $150,000, you instruct your qualified intermediary to wire the $50,000 in capital gains - usually to a title company.
The remaining $100,000 cost of the property would have to be financed either by debt or additional equity, but the $50,000 in capital gains would be deferred, as would the $5,000 in capital gains tax.
You want to sell your commercial property for $600,000. You bought it for $400,000 as an investment. Meaning, the sale will generate a $200,000 taxable capital gain.
If you use a 1031 Exchange strategy, you can defer your capital gains tax with a swap for a like-kind property - another property similar to the one you're selling. But you must identify a like-kind property within 45 days of selling your commercial property. If you do not, you could be subject to a capital gains tax as well as state capital gains.
To ensure compliance, you contact a qualified intermediary who is like an escrow company, to make a qualified exchange arrangement -- the intermediary will transfer your property to the buyer, and transfer the replacement property to you.
What Other Exchanges Are Like a 1031 Exchange?
Similar to a 1031 Exchange is a 1033 Exchange. A 1033 exchange pertains to property involuntarily converted or exchanged - destroyed, stolen, condemned or disposed of under the threat of being condemned. The gain doesn't have to be reported if property received is "similar or related in service or use." There is no time restriction during which a replacement property must be identified, and the proceeds from the involuntary conversion or exchange must be reinvested in property of equal value.
Another similar strategy is a Qualified Opportunity Fund. An investor can defer the tax on the gain from the sale of previous property until the replacement property is sold, or on Dec. 31, 2026, whichever comes first. Meaning, investors using a 1031 Exchange could be able to defer recognition of their gain longer than those using a Qualified Opportunity Fund if the 1031 Exchange property is held after Dec. 31, 2026.
What to Know About 1031 Exchanges
- A 1031 Exchange isn't for personal use. It is only for business or investment property.
- The tax reform law that passed in December 2017 limited exchanges to only real estate.
- Like-kind is relatively vague: Raw land can be exchanged for an apartment building, or a ranch can be exchanged for a shopping center.
- An exchange of property that is an exact match is rare, which is why frequently the exchange is delayed by use of a qualified intermediary.
- A 1031 Exchange has two crucial, non-negotiable, and non-extendable deadlines: 45 days in which to identify a replacement property, and 180 days in which to close on the new property after sale of the old.
- Any cash left over after the sale is a taxable "boot," and will be taxed as capital gain on the sale of your property.
- Consider mortgage and other debt, because the IRS will. If you have a $1 million mortgage on the property you sell, and a $900,000 mortgage on your replacement property, you will have to pay capital gains tax on the difference, as if you received the difference in cash and it were a taxable "boot."