What Is A 1031 Exchange and How Does It Work In Commercial Real Estate?
Reducing Your Tax Liability With Vetted Investments and The 1031 Exchange
Paying taxes can significantly dent the return on your investment. By leveraging IRS-designated tax benefits for commercial real estate investments, you can mitigate your tax liability and keep more of your liquid cash available for other exciting opportunities. If you’re an accredited investor looking to diversify your portfolio and maximize your tax benefits, let’s connect!
What Is The 1031 Exchange?
The 1031 exchange or delayed exchange refers to Section 1031 of the U.S. Internal Revenue Code. This tax code allows you to defer capital gains taxes from the sale of one property when you reinvest those funds in another similar property within the designated timeline.
This tax break is only for properties that are for business or investment purposes, not primary homes. As the property increases in value, the dollar amount at play—and thereby the tax savings—increases with each exchange.
The capital gains tax can range from 0% to 20%, depending on your other taxable income, representing a significant loss of funds if you don’t leverage the 1031 exchange.[1] When you take advantage of this section of the IRS code, you keep more of your liquid funds in your pocket, ready to reinvest.
How Does The 1031 Exchange Work?
The 1031 exchange is often one of the top enticements for real estate investors and commercial joint venture projects. While it sounds simple enough, there is a detailed process that must be followed to utilize this tax benefit for investment properties.
- Sell Property One: For the best tax outcome, this must be a business or investment property in your portfolio for one to two years or longer.
- Purchase Replacement Property: Reinvest the funds from the sale of property one into another like-kind property, also for business or investment use.
- Consult a Qualified Intermediary: Another party designated as a qualified intermediary must handle this transaction.
- Meet Timeline Requirements: There are two windows of time for this tax credit – 45 days to identify the new property and 180 to close on it.
- Taxes Will Be Deferred: Until the new property is sold, there are no new capital gains taxes to pay for the sale of the first property.
- Repeat: This process can be repeated continuously, and capital gains taxes can be tax-deferred if all IRS criteria are met with each transaction.
What Is A Qualified Intermediary?
A qualified intermediary (QI) or exchange facilitator is an uninvolved third party who will hold the proceeds from the sale until the new property is purchased. This is an experienced, professional party who can be relied on to meet deadlines, notify the IRS, and release funds only when appropriate. Potential qualified intermediaries include:
- Your CPA
- Tax Professional
- CRE (commercial real estate) attorney
- Bank or lending institution
What Are The 1031 Exchange Rules?
Can You Do a 1031 Exchange on a Second Home or Vacation Home?
Who Cannot Do A 1031 Exchange?
The 1031 transfer rules and criteria are determined by the IRS. The following breakdown of the exchange process is not intended to be actionable advice but merely a helpful resource. See the 1031 transfer rules, form 8824, and other criteria directly from the IRS here. [2]
- Investment or Business Use: The property being sold must be an investment or business property for productive use. Primary residences do not qualify in most cases.
- Like-Kind Properties: Potential replacement properties must also be a similar property, also designated for investment or business purposes and not as a primary residence for the owning entity.
- A Qualified Intermediary Is Required: This third party upholds the IRS rules and smoothly facilitates the transfer of funds.
- All Funds Must Be Reinvested: If the new exchange property is purchased with only partial funds from the sale proceeds, this will trigger tax liability.
- 45-Day Rule: After the sale of the first property, a new, like-kind property must be identified within 45 days to meet the IRS criteria for the 1031 exchange.
- 180-Day Rule: After the property is identified, you have 180 days to close on the purchase to meet the IRS criteria for the 1031 exchange.
- Property Valuation: The new property must be of equal or greater value than the first property. This is to maintain or increase the potential capital gains tax that may eventually be collected if the cycle is broken.
Can You Do a 1031 Exchange on a Second Home or Vacation Home?
There are some contingencies and special circumstances that may allow a second home to qualify for the 1031 exchange process. If it’s a rental property that generates an income for more time than it is used as the owner’s residence and meets all IRS criteria, it’s possible a second home may qualify for the 1031 exchange. Consult your tax advisor to determine the outlook for your specific scenario.
Who Cannot Do A 1031 Exchange?
Properties outside the U.S. will not qualify for the 1031 exchange. Anyone selling their personal property or primary residence cannot take advantage of this tax break. Properties that are held for the purpose of appreciation and resale are also not eligible.
If you directly receive cash from the sale of the first property, you could be ineligible for the exchange due to the absence of a qualified intermediary. If you choose an intermediary who has some connection to the property or sale, this could also disqualify you from the exchange process.
Types of Investments That Are Considered “Like-Kind” Properties
The 1031 exchange applies to investment and business property holdings that are “the same in nature or character, even if they differ in grade or quality… are like-kind properties regardless of whether they are improved or unimproved…”—According to the the IRS.[3] This could include any one of the following types being exchanged for any one of another type:
- Multifamily complexes or apartment buildings
- Commercial buildings
- Commercial land, with or without improvements
- Industrial properties
- [1]Internal Revenue Service. (n.d.). Topic No. 409 Capital Gains and Losses. Retrieved from https://www.irs.gov/taxtopics/tc409
- [2][3]Internal Revenue Service. (n.d.). Instructions for Form 8824 (2023). Retrieved from https://www.irs.gov/instructions/i8824
Frequently Asked Questions About The 1031 Exchange and Commercial Real Estate Investing
What are real estate debt funds?
Real estate debt funds are an investment strategy that generates income from loan interest rates. Investors contribute to the real estate funds, fund managers determine who they will lend funds to, and investors are paid back from the interest. If the borrower fails to pay, the fund takes ownership of the asset. This is a low-stakes approach to diversify your investment portfolio with real assets at play.
How do I change ownership of replacement property after a 1031 exchange?
If the property is resold or transferred, this will trigger the standard capital gains tax. The property must remain in your portfolio for an extended time, or you will be disqualified from participating in the 1031 exchange.
What is the downside of a 1031 exchange?
The 1031 is an appeal tax benefit but is associated with a few challenges. The type of property that is eligible is narrow, and you must stick to like-kind exchanges. The process is complex and requires the assistance of a professional, qualified intermediary.
If the strict timelines are missed, this will result in an immediate tax liability, and losses on the initial property are not factored in. Even when you successfully complete the 1031 exchange (one time or more), capital gains taxes are never eliminated, only deferred.
What is a reverse exchange?
A reverse exchange is when the new property is purchased ahead of the sale of the property being exchanged. This is a more complex process requiring a third-party accommodator to hold the new property in a single entity LLC until the first is sold. You, as the property owner, are still responsible for all taxes, insurance, and any other expenses while the property is being held.
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Disclaimer: No information provided here should be construed as a guarantee of profit or an offer to invest. There is always risk associated with speculative oil and gas operations, and they represent some level of liquidity risk. Nor should this content be deemed tax advice or legal counsel. TBV works only with accredited investors, and those who meet the requirements should consult with personal or financial consultants before investing.