What is a Section 1031 Exchange?

Commercial real estate investors are always looking for new opportunities. Buying and selling commercial properties comes with a huge tax hit unless you’re making a like-kind exchange. Under Section 1031 of the Internal Revenue Code, like-kind commercial real estate exchanges are tax-deferred—letting investors build wealth over time. 

Like-kind exchanges have been in the tax code since 1921, but their fate was up in the air in 2020. Early indications from the Biden Administration suggested that the tax break would be severely limited. However, the House Ways and Means Committee’s Budget Reconciliation Bill released in September 2021 did not include changes to like-kind exchanges. 

For now, like-kind exchanges remain available—and taxpayer-friendly—for qualifying real estate transactions. 

Let’s Define a 1031 Exchange 

What is a 1031 exchange? It’s essentially an investment “swap” that allows capital gains on taxes to be deferred. Under Section 1031, you can exchange property meant for business or investment purposes for another property of the same type. You aren’t required to recognize any gains from the sale, meaning you don’t have to pay taxes on the sale that year. 

What Are Capital Gains?

Let’s talk about capital gains. You have a capital gain when you sell something for more than what you paid for it. You have a capital loss if you sell a property for less than what you paid for it. Short-term capital gains apply to assets you’ve owned for one year or less, whereas long-term capital gains are assets you’ve had for over a year.

Benefits to Taxpayers: Tax Rates on Capital Gains

Why do a 1031 exchange? It comes down to capital gains. 

With a like-kind exchange, the seller avoids paying taxes on capital gains for the time being. Tax rates on capital gains could range from 15% to 30% when you combine state and federal taxes. If an investor reports a like-kind exchange, they avoid paying taxes until they sell the property for cash years later. 

A 1031 tax-deferred exchange is a strategy that helps you defer taxes and build wealth. It doesn’t help you avoid taxes altogether. Everything is taxable in a 1031 exchange, but you don’t have to pay those taxes the year of the property sale.

There’s no limit to the number of times someone can make like-kind exchanges. You can continue deferring capital gains on commercial real estate investments for a long time. When you cash out, even after turning over numerous properties, you only pay taxes once at a long-term rate.

What Are the Rules of a 1031 Exchange?

The 1031 exchange rules require you to purchase a property of “like-kind” to the one you are selling. But what is a like-kind property anyway? 

As of January 2018, machinery, equipment, vehicles, artwork and intellectual property generally do not qualify for tax-deferred like-kind exchanges. The like-kind exchange rules state that properties must be used for business or held as an investment and be located in the United States. Personal homes and international property don’t qualify under Section 1031. 

“Like-kind” doesn’t mean you have to purchase a commercial property of the same size, quality or type. If you’re selling a multifamily property, you can buy an industrial property. You can exchange your hotel for a shopping center. Whatever the case, both properties must be held for business or investment purposes. The real estate you want to buy must not exceed 200% aggregate fair market value of the real estate you’re selling.

Section 1031 of the Internal Revenue Code explains how a 1031 exchange works. A complete version of Section 1031 regulations can be viewed at the Code of Federal Regulations administered by the Office of the Federal Register (OFR) of the National Archives and Records Administration (NARA) and the U.S. Government Publishing Office (GPO).

1031 Exchange Timeline

If you’re planning a like-kind exchange, you must follow the timeline set by the IRS. The tax-deferred exchange will fall through if you don’t meet the timeline.

45 Days to ID Property

Once you sell your commercial real estate investment, you have 45 calendar days to identify up to three like-kind properties to replace it. In the meantime, an intermediary party will hold the cash from the property sale. You will notify your intermediary of the replacement property in writing within this period.

180 Days to Acquire Property

You have 180 days total to acquire a new property, including the 45-day window to identify properties. (The two windows run at the same time!) During what remains of your 180-day window, you will close on your new investment property. 

If your tax return due date comes before the 180 days are up, you must acquire the property by that date. Before starting this process, be sure to check when your tax return date will be. 

Once you close on the new real estate investment, the intermediary party “buys” the property for you and completes the transaction. You are paid any leftover cash from the sale after 180 days—extra cash is referred to as the “boot.” The amount of the boot is usually taxable.

It is possible to do a reverse 1031 exchange. You can purchase the replacement property first and still defer taxes by reporting on Form 8824

What’s the “Boot” from a 1031 Exchange? 

The boot is not a device used to lock your car tires or the shoes on your feet. In a 1031 exchange, “boot” refers to extra cash or debt reduction involved in the transaction. An investor may receive or give cash in addition to the like-kind property. Because this cash is an additional value, taxes must be paid on it within the year of the 1031 exchange. 

Many people don’t consider their mortgages before initiating a 1031 exchange, and that’s where boot often comes into play. You have a $1 million mortgage, but the mortgage on the new property is only $800,000. The extra $200,000 would be considered boot, meaning you’d have to pay taxes on it. 

The goal of a 1031 exchange is to complete the transaction without any boot. No boot means you’ve achieved a tax-free exchange.

If you’re an investor, 1031 tax-deferred exchanges are one of the best tools out there to expand your wealth and portfolio. It’s always a good idea to work with a financial advisor or tax professional to ensure your exchange goes off without a hitch. 

Are you looking for your next investment? If you’re thinking about investing in a new property, take a look at one of Missouri’s top tourist destinations: Branson.  

Contact Commercial One Brokers to find your next commercial real estate investment in Branson, MO. 

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