A 1031 exchange, also known as a tax-deferred exchange, allows an investor to sell a commercial property and use the profits to purchase another property with the profits while deferring capital gains taxes.
The rate an investor will eventually pay depends on the length of time the property was owned, the taxable income on the asset, and the taxpayers filing status. If the property was owned for less than one year, then the taxpayer would be required to pay according to their federal income tax bracket (ranging from 10%-37%). However, if the property was owned for more than one year, the taxpayer would pay either 0%, 15%, or 20% depending on their income and filing status.
There are specific requirements that allow those investing to successfully complete a 1031 exchange, and the guidelines are outlined in Section 1031 of the Internal Revenue Code.
Which Properties Qualify for a 1031 Exchange?
Only investment properties qualify for the 1031 exchange. This includes assets such as commercial buildings, including retail centers, apartment buildings, office complexes, rental homes, and industrial parks. Residential real estate and properties that are used for personal use, such as personal residences and properties built by a homebuilder do not qualify.
Mixed-use properties, such as a duplex in which the investor lives in one unit and leases the other, may qualify, but only the portion of the property used for investment purposes will qualify.
It is important to note that since the passing of the Tax Cuts and Jobs Act, Section 1031 now strictly applies to exchanges of real property; no longer are exchanges of personal homes or intangible properties permitted.
Since the IRS restricts 1031 exchanges to exchanges when the investor intends to hold the investment, any property exchanged within one year of its original purchase may require additional investigation by the IRS. The taxpayer must prove that their original intention was to hold the investment property.
Which Properties Qualify as the Exchange Property?
To receive total deferral of gain, the taxpayer must purchase a like-kind asset at a value equal or greater than the original asset; all equity must be reinvested. If the acquired property is of lesser value, the taxpayer will be responsible for paying capital gains taxes according to their profits. However, the fair market value of the new property must not exceed 200% of the value of the relinquished property.
Who Qualifies for a 1031 Exchange?
Anyone can qualify for a 1031 exchange. However, the same individual must be engaged in both the sale of the original property and the purchase of the next property. In other words, the same taxpayer must be involved in both transactions.
What Are the Restrictions of the Sale?
First, the transaction must be set up as an exchange prior to the sale of the first property. If this documentation is not completed prior to the sale, then the property sold will be identified as a taxable sale.
Second, during the process, an intermediary must be used. At no point between the sales may the buyer, or the buyer’s agent, possess the funds. The intermediary will then be responsible for utilizing the funds to complete the transaction of the next purchase. The intermediary may not be a relative of the taxpayer, or an employee, attorney, accountant, investment banker or broker, or real estate agent or broker from two years prior.
Third, the taxpayer must abide by the strict timeline set out by the IRS. The potential replacement properties, which is a maximum of three, must be identified within 45 days after the transfer of the exchanged property; the final exchange must be completed within 180 days.
Benefits of a 1031 Exchange
1031 exchanges offer multiple benefits to those who want to buy a commercial property after selling another. As mentioned previously, engaging in a 1031 exchange means a taxpayer does not pay capital gains tax at the time of transfer — instead, the taxes are deferred. According to Section 1031(a), “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
Engaging in a 1031 exchange also allows an investor to acquire a more valuable asset. They can use the equity from the initial property as a down payment for the new property. This can also increase cash flow, providing a higher income for the investor.
Lastly, partaking in a 1031 exchange allows an investor to consolidate, diversify, and simplify their portfolio. If an investor owns multiple properties, they can divert their funds back to one asset; on the contrary, if they own one commercial property type but want to diversify, they can redirect their funds to multiple assets. This exchange is not limited to one state, which provides an abundance of opportunity for any investor depending on their investment goals.