Real Estate Basics 101: The 1031 Exchange

December 24, 2020
empty building with four large windows and a brick wall

As a commercial property owner, the potential to sell your property in today’s hot market is tempered by the stress of calculating the potential capital gain exposure. If you’re contemplating selling your current commercial property and looking to quickly secure a new one, a 1031 exchange might be an excellent fit to help defer capital gain taxes and ease the immediate burden associated with the sale of your property. 

What does a 1031 exchange look like?

As a standard practice, sellers generally have to pay tax on the gain they receive at the time of sale of a business or investment property. In official IRS language, a 1031 exchange, also called a “like-kind exchange,” provides an exception to this rule and allows you to postpone paying tax on the gain of the property you just sold if you reinvest the proceeds in a similar property as part of a qualifying like-kind exchange. It’s important to note that deferring your gain under a 1031 exchange is tax-deferred and not tax-free. 

To successfully accomplish a 1031 exchange, there must be an exchange of properties. The simplest of exchanges would be to swap one property for another, but it doesn’t generally work out that way. To provide more flexibility, the rule extends to include an exchange of property as well as the cash and liabilities attached to it, yet you cannot exchange assets such as inventory or the stocks and bonds that may be attached to the property. 

The easiest way to approach a 1031 exchange is to hire a qualified intermediary, which is a person or company that agrees to facilitate the  exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. As in most legal transactions, the qualified intermediary cannot have a standing relationship with either parties in the exchange. It is also recommended that the owner partner with a commercial broker/salesperson who has experience in successfully navigating the 1031 process.   

What kind of properties are eligible for a 1031 exchange? 

When implementing a 1031 or “like-kind” exchange, the properties involved must meet certain requirements. Here is a list of rules to follow when preparing for your exchange:

  • Quality or grade does not matter. A like-kind property is characterized by its nature, character or class. 
  • The properties must be used for trade, business or investment. A property intended for personal use, such as primary residence or vacation home, does not apply.  
  • The replacement property should be of equal or greater value to fully receive the benefits of the 1031 exchange. 

1031 exchanges are time sensitive 

According to the IRS,  you must meet two time limits for the entire gain of the exchange to be taxable. The first time requirement provides a time frame of 45 days from the date you sell the relinquished property to identify potential replacement properties. To make the identification of your new property official, you must provide proof in writing, signed by you and given to your qualified intermediary. The second time requirement states you must complete the exchange within 180 days of the sale.  

Benefits of a 1031 exchange 

The main advantage to using a 1031 exchange is the ability to dispose of a property without incurring a capital gain tax liability. It provides investors with the leverage they need to acquire a property with more value. Rather than paying the money to the government, the investor can increase their down payment and improve their overall buying power. Making it through the exchange with some extra money to invest, is the perfect opportunity to create wealth within the new property and work towards your future property goals. 

Important Nuances of the Exchange Process

It is important to note that a property owner wishing to take advantage of the 1031 exchange process designate the property to be purchased.  This portion of the transaction is called a “upleg”.  Up and until the 45 days following the sale of the initial asset, referred to as “the downleg”, the property owner can designate as many as 3 potential properties to purchase and qualify for capital gain shelter.  If the owner does not close on any of these three properties by the end of the 180 day period, then they will be responsible to pay full capital gains.  That being said, the buyer can change any and all of these 3 properties as many times as they wish within the first 45 days by giving written notice to their intermediary.  A good commercial agent will have already lined up multiple suitable purchase options for the owner in advance of them closing on the original asset.  

Additionally, for a nominal fee to intermediary a property owner can take advantage of what is referred to in the industry as a Reverse Exchange. A reverse exchange is a type of property exchange wherein the replacement property is acquired first, and then the current property is traded away. A reverse exchange was created to help buyers purchase a new property before being forced to trade in or sell a current property, which greatly reduces the stress of selection, while on the clock.  That being said, it also requires additional equity as you have to carry both properties until sale of initial investment property.  

There are many reasons why you might find yourself in a position where you must acquire, or would prefer to acquire, your replacement property before you sell your current relinquished property in your 1031 Exchange. 

You might unexpectedly find an investment opportunity that you must act upon before you even have time to consider selling or listing your current relinquished property.  The sale or disposition of your relinquished property may unexpectedly get derailed and you do not want to lose your acquisition that is already scheduled to close.  Or, you may prefer to buy first to eliminate the pressure and risk of having to identify your replacement property within the 45 calendar day identification deadline in a regular Forward 1031 Exchange. 

Whatever your reason for deciding to purchase your replacement property first, the Reverse 1031 Exchange allows you to acquire your replacement property first and then subsequently list and sell your relinquished property within the prescribed 1031 Exchange deadlines.  It can be a great strategic tool when needed or desired and should be facilitated by a knowledgeable broker who understands these nuances.

Investing towards the future. 

As you consider your business’s future, consider the benefits of a 1031 exchange. Deferring your taxes and investing more cash into your property goals is the foundation to building your overall wealth. At Barkett Realty, we’re uniquely experienced in all things commercial real estate, and we’re happy to lend our expertise on your 1031 exchange.

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