Commercial real estate investment can be complex, especially when you get into some of the more granular details and processes. For some investors, growing a portfolio is a key to success. In order to do this, there are many different opportunities to buy, sell and trade commercial real estate properties. When a real estate investor knows they want to sell one property and buy another for investment or business purposes, they can conduct what is referred to as a 1031 exchange.
The term itself comes directly from the IRS. In the Internal Revenue Code (IRC), section 1031 states, “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind, which is to be held either for productive use in a trade or business or for investment.”
A 1031 exchange in commercial real estate brings opportunities for investors to move from one property to another, while seeing tax benefits on sale profits to bring more capital into a new property. But a 1031 exchange also has a lot of elements that need to be included in order to qualify for the tax benefits. There are certain parameters, specific rules, and hard deadlines that have to be met throughout the entire process for an investor to be able to qualify for a 1031 exchange.
Because 1031 exchanges help investors to increase wealth, save on taxes with the tax deferrals, and grow portfolios, they are incredibly popular. Here’s a guide to understanding 1031 property exchanges, how they work, and what to expect going into the process.
What is a Property Exchange?
A property exchange is a swap of properties held for business or investment purposes. There are a few key requirements put forth for property exchanges; the primary one is that the properties must be considered like-kind by the IRS for capital gains taxes to be deferred. When done correctly, there is not a limit on how many times or how often investors can do 1031 exchanges of investment properties.
What is a 1031 Exchange and How Does It Work?
A 1031 exchange is a real estate transaction that allows an investor to avoid paying capital gains taxes when selling an investment property by reinvesting profits into another similar property within a certain timeframe.
For example, if an investor sold a commercial property for a $500,000 profit, and your capital gains tax rate is 20 percent, then that investor owes $100,000 on the sale of that property. However, if they choose to do a 1031 exchange, then that investor can just reinvest the $500,000 profit into another commercial property that costs the same or more than the one that just sold. That investor would then avoid paying taxes on it!
Sounds simple, right? There are a few rules investors have to follow to make sure there are not any issues with the property exchange.
How Do 1031 Exchanges Work?
When an investor sets out to do a 1031 exchange, there are certain steps that need to be followed and deadlines that need to be met in order for the property swap to be considered a 1031 exchange. If anything is missed or done incorrectly, an investor could still owe taxes on the property sale. That’s why working with an experienced professional to do the 1031 exchange is key. Here are the five steps to follow when conducting a real estate transaction for a 1031 exchange.
- Find a qualified intermediary to conduct the exchange.
The money received from the sale of a property is taxable, so the investor should not receive that money. Taking control of the money involved in the exchange before it’s completed could result in a disqualification of the transaction, meaning the investor will owe taxes on the capital gains. A qualified intermediary will help with the exchange and act as a middle man for the 1031 exchange process. They will hold the proceeds from the sale of the property before the purchase of a new one is complete.
- Sell the current commercial real estate property.
When the intermediary is in place and ready to go, an investor can sell the property they are looking to sell. There’s only a small window to find a replacement property, so once the sale is completed, be ready to move on to the next step quickly. Do not forget that only the intermediary can handle the exchange funds generated by the sale of that property.
- Identify a replacement property within 45 days.
There’s not a lot of time to do this step, which is finding the replacement property for your sale. Once the property is sold, there are only 45 days to identify replacement properties. There are no exceptions or extensions for this timeline. A replacement property needs to be like-kind replacements, for business or investment purposes only, not for private use. Once an investor has found a new property, the identification needs to be made in writing and signed. It then needs to be delivered to someone involved in the exchange, like your intermediary.
- There are 180 days to close on the replacement property.
Once you have identified that new property, use the funds from the sale of the other investment property for the purchase of this one. You have just 180 days from the day of the sale of the old property to close on the replacement one.
- File IRS Form 8824.
Now, it’s paperwork time. Investors need to fill out IRS Form 8824. This form reports like-kind exchanges for business and investment properties. A qualified real estate professional and tax professionals can help make sure all the information for the 1031 exchange is done correctly and on time.
What Property Qualifies for a 1031 Exchange?
A 1031 exchange has to be done between what the IRS considers like-kind properties. What that means is that both properties involved in the exchange must be used for business or investment purposes. However, they do not have to be exactly the same! If you are selling off a convenience store, you do not have to replace that with another convenience store.
When you are looking for a replacement property, properties do not need to be the same type. As long as the properties are used for business or investment purposes, that qualifies under the IRS rules for like-kind.
Properties can be located anywhere in the United States. The properties do not need to be in the same city, or even the same state, to qualify. If an investor wants to sell off an East Coast property to expand to the West, then that works too!
Multiple properties can be included in an exchange. If an investor decides to sell one property and buy three others with the profits, as long as all three of those properties will be used for business or investment purposes, the transactions will qualify for an exchange.
A replacement property, or properties in some cases, need to be of equal or greater value to the value of the one that was sold in order to receive a tax deferred status. However, if the replacement property is worth less than the original property, then the investor will pay taxes on the difference.
How Long Do You Have to Hold Property in a 1031 Exchange?
The IRS does not specify a time period for holding investment properties in most cases. The timeframe is less important to the IRS than the intent of acquiring the property: Was the property held as an investment? That is the key question with a 1031 exchange.
While there is no strict time period, the government has suggested a time period of one year several times, so many people understand this as the general guideline. The IRS tax code also differentiates a long-term capital gain from a short-term capital gain at the one-year mark.
However, as indicated above, there are certain scenarios where there is a specified length of time. In Section 1031, the only minimum required hold period is a “related party” exchange, with a required hold of a minimum of two years.
Work with Professionals with 1031 Exchange Experience
When you set out to conduct a 1031 exchange, you want to have a team of professionals who can help make the process seamless and stress-free. There are a lot of moving parts with a 1031 exchange, and deadlines that need to be met. A qualified intermediary and real estate team can help you navigate the rules, regulations, and timelines that need to be followed.
The experts at Sands Investment Group have extensive 1031 exchange experience. Our team can help investors to navigate all of the rules, so you understand your options and the requirements in order to get the full benefits of a 1031 exchange. Get in touch with a 1031 exchange expert today by calling 844.4.SIG.NNN or sending us an email at info@SIGnnn.com.