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As commercial brokers, it is part of our job to help our clients make the best real estate decisions that are appropriate for their situation. One of the tools available for doing that with commercial real estate investors is a 1031 exchange, also known as a like-kind exchange. While this tool isn’t for everyone, it is one of the strategies that we get asked most about. For anyone interested in real estate investing, it’s worth having at least a working knowledge of what a 1031 exchange is and what its potential benefits are.
Disclaimer
The information included in this article is for general educational and informational purposes only. For advice and guidance on potential legal and tax implications regarding a 1031 exchange, be sure to consult with a trusted real estate tax advisor and attorney as part of your team of commercial real estate professionals.
What is a 1031 Exchange?
According to broker Brad Gregory, “A 1031 exchange allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale in a property or properties of like kind and equal or greater value.” It gets its name from Section 1031 of the Internal Revenue Code and basically means that there’s nothing to be taxed if the profit from the sale is immediately invested into another property.
It’s important to keep in mind though that as broker Graham Storey points out, “A 1031 is a way of deferring taxes so investors can reinvest in property.” This can be done repeatedly as you turn properties over, but eventually capital gains will have to be paid when your final replacement property is sold.
Benefits of a 1031 Exchange
Other than the obvious benefit of deferring taxes, there are other advantages to a 1031 exchange, both for investors and for the economy as a whole. Broker Charles Bartscher says that a 1031 is a good way to diversify into other types of properties, which helps to spread out risk. He gives the example of someone selling a Dollar General and exchanging into a Caliber Collision. This helps the investor to diversify their portfolio.
Another benefit, according to Graham Storey, is that by allowing investors to reinvest in property, 1031 exchanges help to keep money flowing in the economy. This, in turn, is something that is good for all of us.
Important Things to Keep in Mind With a 1031 Exchange
While 1031 exchanges may sound like a straightforward strategy, there are a number of things that need to be kept in mind before going down this road. Here’s a look at three of the most important.
There is a strict time limit. Broker Michele Stewart says that “The 1031 Exchange Timeline 45 day rule states you have 45 days to identify a like kind property from the day your current property closes and the funds are deposited with a qualified intermediary.” This rule was set by the IRS to ensure that you identify a replacement property in 45 days or less and close within 180 days.
Have a good idea of where you’re going to reinvest the profit, before you sell. This is important according to Brad Gregory because you don’t want to sell and then not have a readily available option for reinvestment, which is especially important given the 45-day time limit in the current market. An experienced broker can help make sure that you have a plan prior to closing on the property that you want to exchange so that you can meet the time limit. For more on the current trends and challenges that we’re seeing regarding 1031 exchanges, be sure and read this article.
Personal property is excluded. The IRS emphasizes that a 1031 is “When you exchange real property used for business or held as an investment solely for other business or investment property.” In other words, the profit from the sale of a commercial property cannot be used to buy a property that you intend to live in and still avoid paying capital gains on those profits.
Bottom Line on 1031 Exchanges
The bottom line on a 1031 exchange is that they can be a useful tool for commercial real estate investors, but as with any strategy, you need to determine whether they are a good fit for your individual situation. To do that, be sure to consult with a trusted real estate tax advisor and attorney and include a knowledgeable Pickett Sprouse broker as part of your team of commercial real estate professionals.
How to ask us a question
Our brokers will be answering your questions every month through the Ask a Broker series. If you have a commercial real estate question that you want answered, we’d love to hear from you at marketing@westandwoodall.com.