Every client is a strategic partner, a business owner, and usually, an investor. Real estate is a fantastic form of investment to engage in, and that’s due in part to the extraordinary amount of tax incentives and strategies that benefit folks who own and sell commercial property. Today, I’m putting the spotlight on one of my favorites: 1031 exchanges for commercial real estate transactions.
To be clear, you have to own property first, but this strategy is one every business owner needs to know about. Let’s get into the details.
With a 1031 exchange, you can sell and acquire properties without capital gains taxes taking a bite out of each transaction.
The designation “1031 exchange” is a reference to its origin, which is in Section 1031 of the Internal Revenue Code—a tangle of rules and regulations concerning the sale of commercial property. 1031s are straightforward in the literature but, in practice, not so much.
To clarify, 1031s “defer” (not eliminate) capital gains taxes.
Setting up a 1031 exchange allows businesses and individuals to defer the taxes that they would ordinarily owe on profits gained from the sale of a property. If you reinvest the proceeds from these transactions in real estate while following the Internal Revenue Service (IRS) rules, you can avoid paying taxes on your gains for a long time.
All companies and individuals can engage in 1031 exchanges for commercial real estate transactions, and there are no limits on how many 1031s an individual may engage in.
“Sure, I completed four billion transfers this year. It’s a robust portfolio.” Even though it would be impossible to transfer four billion properties, a property owner could say that and mean it and not get a letter from the federal government. I really do love this country.
Properties must be used for business or investment purposes—and other strange rules.
Taxes on the sale of real estate used for “a trade or business or for investment” are eligible to be deferred using Section 1031 for commercial real estate transactions. The IRS defines “trade or business” as “any activity carried on for the production of income from selling goods or performing services.”¹
Under Section 1031, most business or investment properties within the U.S. can be exchanged for like-kind properties, which means a property of equivalent value. However, developed properties that are not being used for business purposes and were improved have to be rental properties to qualify for a 1031 exchange. Land does not have to be rented to qualify for an exchange.²
You need to know if your property is eligible before you take out a mortgage.
Property that’s primarily utilized for an individual’s purposes is not eligible for a 1031 exchange unless they are rented out for a significant time to someone else. In other words, your primary residence, your secondary home, and your vacation home cannot be part of an exchange unless they’ve been rented previously.
Property outside the U.S. cannot be involved in a 1031 exchange.
Every 1031 exchange involves a third party who (temporarily) holds the rights and proceeds of your property.
A third party, called an “accommodator,” is legally required to participate as a sort of intermediary in the exchange. Accommodators hold your profits until the purchase of your new property is completed. You cannot obtain any benefits from selling your property until you finish buying the new asset.²
Accommodators obtain the rights to the property and the proceeds from the sale and transfer the funds to an escrow account. These funds are used to buy the new property.
The funds can be utilized to cover closing costs and pay off any mortgages or deeds on the property that you’re selling. But you must pay taxes on any of the profits that you use to pay off other debts or loans.
Get an agreement signed on your next property long before you initiate an exchange.
Listen up here. You must identify and state in writing the property or properties that you will buy within 45 days of completing the sale of a property. Typically, the new or replacement real estate is disclosed by sending a letter to the accommodator.
You must close on the new property or properties within 180 days of completing the sale of the real estate that you are divesting. Additionally, you must finish the sale of your real estate before you file your next tax return.
Everything you need to know about the “two-year rule.”
If your exchange involves one or more transactions with a related party, the two-year rule is applicable. The two-year rule states that, in a transaction with a related party, the acquirer must hold the property for at least two years.
The two most common types of related parties are either blood relatives or entities that the seller partly owns.
Property owners can use depreciation deductions from their tax bills. However, when real estate is sold, the IRS usually forces taxpayers to pay a portion of the taxes that they previously avoided due to depreciation deductions. This phenomenon is known as “depreciation recapture.”
Using a 1031 exchange, you can defer taxes that you owe due to depreciation recapture.
Avoid blundering into paying capital gains taxes by not doing these three things.
Of course, the reason that businesses and individuals employ 1031 exchanges for commercial real estate is to avoid accumulating taxable gains. That’s the whole point of this exercise. But people make mistakes, and when it comes to property sales, a “mistake” means the government snatches 20% of the profit from folks in high-income tax brackets.
Here are a few ways property owners catch tax bills:
Blunder #1: Bob buys a property for $200K. He sells his property for $300K in cash. That’s not a transfer, and it cannot be retroactively turned into a transfer.
Result: Bob pays the government $20,000—20% of the profit he made from the sale.
Blunder #2: Brenda assumes nobody will notice that the value of the property she sold is much less than the value of the property she intends to acquire through her D.I.Y. 1031 exchange. Bad idea, Brenda. At best, Brenda’s experiment will earn her a big tax bill or, worse yet, a charge in federal court for tax fraud.
Result: No deal. Capital gains taxes due.
Blunder #3: Travis and his “team” forget that the debt owed on their old property should match the debt owed on their new property.
Result: A letter from the Internal Revenue Service.
Also, if you obtain a higher-value mortgage for your new property or asset than the property designated for a transfer, you’ll owe taxes on the difference between the two.
Set up a 1031 exchange for commercial real estate transactions.
Work with us, and we can manage your 1031 exchanges so that you can build your real estate portfolio without paying out the nose in taxes every time you complete a transaction.
Schedule a consultation today, and let’s get started.
Talk soon,
Jeremy A. Johnson, CPA
References
- Definition of Trade or Business | Internal Revenue Service [Internet]. Irs.gov. 2016 [cited 2024 Aug 10]. Available from: https://www.irs.gov/charities-non-profits/definition-of-trade-or-business#:~:text=The%20term%20trade%20or%20business
- Exchanges under Code Section 1031 [Internet]. americanbar.org. 2023 [cited 2024 Aug 6]. Available from: https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/