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1031 Exchanges in Commercial Real Estate
A 1031 exchange allows a commercial property seller to defer taxes from the sale of a property if they acquire another, similar property within 180 days.
What Is a 1031 Exchange in Commercial Real Estate?
When an investor or developer sells a commercial property, they are obligated to pay tax on the transaction. One exception to this requirement is if they transfer the property through a 1031 exchange is a transaction that allows a commercial property seller to defer paying taxes on the sale of the property if they use the funds to buy another, similar property within 180 calendar days.
Who Can Use a 1031 Exchange?
Individuals, S corporations, C corporations, trusts, LLCs, and other groups are eligible to request a 1031 exchange for the purpose of deferring their tax burden until later.
It's important to realize that 1031 exchanges are designed for the exchange of commercial properties. As a result, personal homes and vacation residences are typically not eligible.
In addition, the seller cannot simply use money from the sale of the first commercial property to purchase the second commercial property; the two deals must be part of the same legal transaction (at least from the perspective of the IRS.)
Eligible Commercial Properties for 1031 Exchanges
It's possible to use 1031 exchanges with many different types of commercial real estate. See the list below for some examples:
- Office buildings
- Retail centers
- Industrial properties
- Multifamily properties or apartment complexes
- Hotels and motels
- Self-storage facilities
- Agricultural land
- Undeveloped land
- Mixed-use properties
- Medical office buildings
- Churches
- Theaters
The properties exchanged must be of “like kind”— for instance, a boatyard could not be exchanged for a shopping mall.
The new property must be located within 45 days of the sale of the initial property, and purchased within 180 days of the initial property’s sale.
The 1031 exchange must be performed by a qualified intermediary.
Titles to property cannot be in held by two people at the same time.
A replacement/exchange property needs to be worth equal to or more than the original property.
If the original property had debt on it, the new property must take on at least that amount of debt.
Leftover cash from a 1031 exchange, referred to as “the boot” is taxed as ordinary income.
Any reduction in debt you have with the new property (for instance, if you had $2 million of debt on the original property and only $1.8 million on the new one) will also be taxed as ordinary income.
What is a 1031 Exchange in commercial real estate?
A 1031 Exchange in commercial real estate is a transaction that allows a commercial property seller to defer paying taxes on the sale of the property if they use the funds to buy another, similar property within a specific period of time. Individuals, S corporations, C corporations, trusts, LLCs, and other groups are eligible to request a 1031 exchange for the purpose of deferring their tax burden until later. However, it's important to realize that 1031 exchanges are designed for the exchange of commercial property. As a result, personal homes and vacation residences may not be eligible. In addition, the seller cannot simply use money from the sale of the first commercial property to purchase the second commercial property; the two deals must be part of the same legal transaction (at least in the perspective of the IRS).
For instance, if an investor sold a small shopping mall (with no debt) for $10 million, they would have $10 million in capital gains, on which they would likely have to pay around 35% in taxes (combining federal and state capital gains, depreciation recapture, and net investment taxes). That would leave them $6.5 million to re-invest into another property. If the investor had to put down 30% (at 70% LTV), they would be able to purchase a property worth $21.66 million. However, if they were able to exchange the property, they could invest the entire $10 million as a down payment, allowing them (assuming the same LTV ratios), they would be able to purchase a property worth up to $33.33 million. As you can see, simply deferring taxes to later allows borrowers to take advantage of significantly more leverage, which can exponentially increase investment returns in the long run.
What are the benefits of a 1031 Exchange in commercial real estate?
A 1031 exchange in commercial real estate allows investors to defer the payment of capital gains taxes to the IRS, as long as they exchange their property for another “like-kind” commercial property within a certain period of time. This like-kind property must be of greater or equal value to the initial property, and cannot be a single family home used as the owner’s personal residence.
In addition, the seller cannot simply use money from the sale of the first commercial property to purchase the second commercial property; the two deals must be part of the same legal transaction (at least in the perspective of the IRS).
By deferring taxes to later, borrowers can take advantage of significantly more leverage, which can exponentially increase investment returns in the long run. Individuals, S corporations, C corporations, trusts, LLCs, and other groups are eligible to request a 1031 exchange for the purpose of deferring their tax burden until later.
For more information, please visit https://www.commercialrealestate.loans/commercial-real-estate-glossary/1031-exchange.
What are the risks associated with a 1031 Exchange in commercial real estate?
The main risk associated with a 1031 exchange is that the investor must purchase a replacement property within a certain period of time. If the investor fails to do so, they will be liable for the taxes on the original sale. Additionally, the replacement property must be of equal or greater value than the original property, and the investor must reinvest all of the proceeds from the sale of the original property into the replacement property. If the investor does not reinvest all of the proceeds, they will be liable for taxes on the difference. Finally, the investor must identify the replacement property within 45 days of the sale of the original property, and close on the replacement property within 180 days of the sale of the original property. If the investor fails to meet any of these deadlines, they will be liable for the taxes on the original sale.
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What are the requirements for a 1031 Exchange in commercial real estate?
In order to make 1031 exchanges successful, investors must follow certain rules. These include:
- The properties exchanged must be of “like kind”— for instance, an boatyard could not be exchanged for a shopping mall.
- The new property must be located within 45 days of the sale of the initial property, and purchased within 180 days of the initial property’s sale.
- The 1031 exchange must be performed by a qualified intermediary.
- Titles to property cannot be in held by two people at the same time.
- A replacement/exchange property needs to be worth equal to or more than the original property.
- If the original property had debt on it, the new property must take on at least that amount of debt.
- Leftover cash from a 1031 exchange, referred to as “the boot” is taxed as ordinary income.
- Any reduction in debt you have with the new property (for instance, if you had $2 million of debt on the original property and only $1.8 million on the new one) will also be taxed as ordinary income.
Individuals, S corporations, C corporations, trusts, LLCs, and other groups are eligible to request a 1031 exchange for the purpose of deferring their tax burden until later. However, it's important to realize that 1031 exchanges are designed for the exchange of commercial property. As a result, personal homes and vacation residences may not be eligible. In addition, the seller cannot simply use money from the sale of the first commercial property to purchase the second commercial property; the two deals must be part of the same legal transaction (at least in the perspective of the IRS).
What are the tax implications of a 1031 Exchange in commercial real estate?
A 1031 exchange is a popular tool for commercial real estate investors to defer paying capital gains tax. It requires divesting from one asset and replacing it with another, similar property within a certain time frame. The IRS is strict about 1031 exchanges, so you need to be sure you are following the rules exactly. Additionally, homes used as a primary residence are not eligible. By engaging in a 1031 exchange, investors can avoid paying taxes in the present, as a dollar now is worth more than a dollar tomorrow. Some investors even elect to exchange properties indefinitely, acquiring increasingly profitable pieces of commercial real estate while avoiding capital gains taxes.
There are many other types of properties that can also be transferred, but the more specialized the asset, the harder it is to transfer, thanks to the "like kind" rule of 1031 exchanges.
What Are the Rules of 1031 Exchanges?
While we already mentioned a few of them above, there are quite a few rules that investors must follow in order to make 1031 exchanges successful. They include:
Can You Get Extra Time to Complete a 1031 Exchange?
Yes, in some cases, you can. One type of IRS 1031 exchange, known as a reverse exchange, allows investors to identify and purchase the similar property before selling the initial property they want to exchange. Investors can do this by hiring an exchange facilitator, often known as an exchange accommodation titleholder (EAT), a legal intermediary who holds the titles of one or more of an investor's properties while they complete the 1031 exchange.
Crowdfunding and 1031 Exchanges
In today’s marketplace, crowdfunding has become an increasingly popular way to raise money for real estate investing. Accordingly, some companies have created vehicles that allow individuals who have sold property in a 1031 exchange to invest the proceeds into crowdfunded properties. By doing this, an investor could invest in a larger property or a group of properties that could, potentially, reduce their expenses and their required legwork, while at the same time raising their potential return.
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