IRS 1031: A Preferred Strategy for Commercial Real Estate Investors

Northeast Private Client Group

It should come as no surprise that with capital gains taxes on the rise, the “1031 exchange” is increasingly the preferred strategy for active real estate investors.  Deferring capital gains liability allows an investor to acquire additional properties with funds which otherwise would have been paid to the IRS.  What’s not to love?

Tax deferred exchanges are not new – they’ve been available in one form or another since 1921.  In its current form since 1986, a “1031 exchange” is a roadmap for selling one qualified property and buying another qualified property within a specific time period.  Property to be exchanged must be held for business or investment purposes and not primarily for resale or personal use.

While we would never discourage anyone from investing in the stock market as a strategy to grow their net worth or at least keep ahead of inflation, we believe that joining a 1031 strategy with commercial real estate offers a much better road to both of those same destinations.

Although the logistics are practically the same as any regular sale and buy transaction, a “1031 exchange” is unique because the entire transaction is treated not as a sale, but as an exchange.  The beauty here is that sales are taxable with the IRS, while “1031 exchanges” are not.  What we have here then is an IRS-recognized approach to the deferral of capital gain taxes.

We are currently facilitating more than a half-dozen exchanges for clients that are buying a replacement “like kind” property after the sale of an existing investment property.  Any other strategy would necessitate paying a capital gains tax, which would reduce their buying power by the amount of the capital gains tax; i.e., it would only be 70-80% of what it was before the exchange and tax payments were made.

The two major rules of a “1031 exchange” are:

  • The total purchase price of the new “like kind” property must be equal to or greater than the total net sales of the property that was sold.
  • All of the equity received from the sale of property must be used to purchase the new “like kind” property.

Beside these two major rules, there are also a number of guidelines that must be followed, including:

  • Both properties must be held for a productive purpose in business or trade as an investment.
  • The proceeds from the sale must go through the hands of a “qualified intermediary” (QI) and not through your broker’s hands or the hands of one of his or her agents or else all the proceeds will become taxable.  QIs are companies that work full-time on facilitating 1031 exchanges, and the tax code demands that QIs are independent organizations whose only contact with the exchanger is to serve as a QI.
  • The replacement property must be subject to an equal or greater level of debt than the property sold; if not, the buyer will be forced to pay tax on the amount of decrease.  If not, then the buyer will have to put in additional cash to offset the low debt amount on the newly acquired property.
  • The period of time in which the new property is received ends exactly 180 days after the date the sold property was transferred — even if this falls on a weekend or holiday — or the due date for the exchanger’s tax return for the taxable year in which the property was transferred, whichever comes earlier.

While you can see the benefit of the “1031 exchange,” it’s vital to follow the guidelines to gain these benefits.  That’s where we come in.  With offices in New York, Connecticut and Massachusetts, our investment sales team has deep experience with the “1031 exchange” process.  If you’re a property owner or an investor in the mid-market segment and want to discuss a possible “1031 exchange” or your overall investment goals and how we can help you achieve them, please give us a call.  We look forward to hearing from you.