What You Need to Know Before Implementing a 1031 Exchange
Owning or investing in commercial real estate is better than renting space, especially if you are engaged in trade or business. It is also a good way of diversifying your investment portfolio.
One of the chief reasons investors find this type of investment attractive is that real estate always appreciates.
Section 1031 of the Internal Revenue Code (IRC), also known as the Starker exchange or like-kind exchange, makes investing in commercial real estate more appealing. This legislative provision provides protection for investors of real estate. It applies to real estate properties that are exchanged for like-kind properties that are held for investment, business, or trade. It does not apply to personal real estate properties, such as heavy machinery and equipment.
With this law, the tax treatment for real estate exchanges remains unaffected despite the enactment of the Tax Cuts and Jobs Act (TCJA) in 2018. With a 1031 exchange, no outright gain or loss is recognized at the time of the exchange.
How a 1031 exchange helps property investors
When not electing a 1031 exchange, the real estate owner is generally liable for four types of taxes at the time of the investment property’s sale. These taxes are the following:
- the state tax, the rate of which depends on the state where the property is located;
- a 3.8% net investment income tax, if applicable;
- a 15% or 20% federal capital gains tax, depending on the individual’s taxable income; and
- a 25% depreciation recapture.
Although Section 1031 does not exactly mean the exchange is tax-free, it surely provides the investor the opportunity to defer payment of capital gains taxes.
As an investor, it is your choice whether to sell, hold, or exchange the property. The tax implications and tax treatment of each option vary.
By choosing to defer these taxes, you will have more resources available for investment in other assets to diversify your mixed-asset portfolio. Indefinitely avoiding these taxes is also possible. The only time you will have to pay them is when you sell the property for proceeds.
Another advantage of doing a 1031 exchange is the possible relief from repairs and maintenance costs. Since you can dispose your property and reinvest in replacement property, which requires less maintenance, the costs you paid for the previous property can be avoided in the future.
How to qualify for a 1031 exchange
Not all real estate exchanges are afforded the protection of Section 1031 of the IRC. Here is a brief discussion of what to do in order to qualify for a like-kind exchange.
The real estate properties to be exchanged must be like-kind
Real estate properties held primarily for sale are excluded from this protection. To qualify, the real estate held must be for productive use either in trade, business, or for investment only.
Also, “like-kind” does not necessarily mean the exact same use or the same type of property. Exchanging, for instance, an apartment building for a strip mall still comes within the protection of section 1031. Commercial real estate may also be traded for residential property.
The replacement property must be identified within a period of 45 days and acquired within six months
A qualified intermediary performs the transaction. This intermediary is not allowed to give the investor any cash received from the disposal of the old property; instead, they hold the cash until a like-kind real estate is purchased within 180 days. Giving the cash proceeds to the owner will take the transaction out of Section 1031.
Investors are given a limited period to find and purchase a replacement property. Within 45 days from the sale of the old property, the owner must designate the replacement property.
The designated property must be specified and communicated in writing to the qualified intermediary. The IRS allows the owner to designate more than one property if the properties designated pass certain valuation tests.
Additionally, the owner must close on one of the designated properties within 180 days from the sale of the old one. These two periods run concurrently. As such, the later you designate, the less time you will have to close the replacement property.
There are 1031 exchange firms that are dedicated to helping facilitate a 1031 exchange and to assisting investors in the process. They can also serve as the qualified intermediary.
Taxes on any proceeds received from the transaction must be paid in the year the exchange occurred
Capital gains are taxable. Any proceeds received after the sale will be taxed outright and are not deferred. These proceeds are more commonly called the boot and are not necessarily limited to cash proceeds.
Any asset or liability that is not like-kind will be taxed outright. This will make the transaction only partly taxable and the taxable portion is limited only to the value of the proceeds.
Why investing in commercial real estate is an excellent idea
Returns and cash inflow from real estate investments are more stable than other types of assets
Like many types of investments, investing in real estate properties doesn’t always mean getting increasing returns. However, you’re surely getting a positive and steady return from such investments.
The National Council of Real Estate Investment Fiduciaries (NCREIF), the body in charge of measuring the performance of real estate properties, reported in 2018 a 6.72% annual return in operating real estate properties.
This is broken down as follows: 1.70% in the first quarter, 1.81% in the second, 1.67% in the third, and 1.37% in the last. The quarterly returns are expected to fluctuate, but these investments have been historically reported to have low volatility. Compared to other types of assets, such as bonds and stocks, the fluctuations are not as drastic.
The NCREIF property index (NPI) provides information that dates back to 1977. This measurement applies exclusively to operating apartments, offices, hotels, and retail and industrial properties. As of 2018, the total market value of these real estate properties is at $611,655,051,001.00. For the last 5 years, an average annual return of these investments is 9.85%.
Although this measurement does not cover all real estate properties, it covers those that are at least 60% leased. In this regard, the NPI is considered a reliable indicator of the performance of real estate investments.
Protection from the negative impacts of inflation is ensured
The behavior of the economy surely affects all types of businesses. However, some types of businesses suffer less than others, especially over the long term. This is one of the benefits commercial real estate investors consider. For instance, the ability of the owner to adjust the rent and other passive incomes being generated from the commercial property offsets the negative effects of inflation.
The advantage to business owners is guaranteed when real estate exchanges occur
There are no restrictions in the frequency of conducting 1031 exchanges. Since businesses comprise many types of assets, such as property and equipment, buildings, and lands, doing a 1031 exchange for commercial property is highly likely. This is very true especially for businesses that are planning to expand their operations.
Although Section 1031 of the IRC has limited applications and can only be availed for a limited period, it greatly reduces the amount of taxes you will pay in the year of the like-kind exchange. By avoiding taxes within this period, you have the opportunity to further diversify your assets and expand your business operations.