June 16, 2021

What is a 1031 Exchange?

If you are interested in, or already own investment real estate, you should know about the 1031 tax-deferred exchange. The United States Tax Code incentivizes real estate owners to continue their investment by offering to defer capital gains tax through the re-investment of profit into higher valued or larger properties. To facilitate the sale and purchase of new investment real estate properties, a 1031 exchange can be performed. This tax-deferral program allows investors to capture the increase in equity or profit from the sale a property and then use that gain to purchase a like-kind property without having to pay a capital gains tax.

Understanding the 1031 Exchange
Section 1031 of the U.S. Internal Revenue Code explains how the owner of an investment property can avoid or postpone capital gains tax on their property after sale if the proceeds are reinvested in similar property within certain time parameters. This is referred to as a 1031 exchange and there are certain factors that need to be met for transactions to be eligible.

What Qualifies as a 1031 Exchange?
While the properties involved in a 1031 exchange should be similar, they don’t need to be identical in all aspects. Like-kind property essentially means that you’re replacing one investment property with another investment property. This is only applicable for business property—personal use property often does not qualify.

For example, the most typical 1031-Exchange transactions we see is when owners of California apartment buildings sell their properties at sub 4% cap rates and “exchange” into more passive vehicles such as Single-Tenant NNN properties that have 6%+ cap rates.

Qualified Intermediaries
Like an escrow company and service, a qualified intermediary is a person or company who has been designated to facilitate the 1031 exchange. They are responsible for holding the funds from the sale property in escrow until they can be transferred to another property. This is done for legal reasons and therefore, whoever is designated as the qualified intermediary cannot have any type of relationship with either of the parties involved in the sale and purchase of the 1031 exchange properties. This is to avoid paying immediate income tax on the proceeds from the sale of the original property. You will still, however, need to pay capital gains tax at some point if or when you decide to sell and discontinue owning investment real estate.

When a 1031 Exchange is Beneficial
The instances in which a 1031 exchange is beneficial depends on the investor profile, risk appetite, and the purpose of the original investment. If you are interested in selling a current income property and believe that a different property, or asset class, will generate greater returns over time, a 1031 exchange maybe worth considering.

The 1031 exchange can help with real estate portfolio diversification.
For instance, some investors want a combination of different asset classes in their portfolio to ensure that there is no major concentration to one-type of tenancy. The most common transaction is owners of apartment buildings diversifying into other commercial real estate investments, such as retail, office, industrial, self-storage etc.

The Step-Up in Basis
The tax deferment debt can be eliminated if the investor passes away and the 1031 exchange is inherited by an heir. If an investor dies before they’re able to sell a property that was acquired through a 1031 exchange, the heir will receive the property at the current market value and deferred taxes will be permanently erased.

While there are many benefits of a 1031 exchange, the most common reason real estate investors participate in a 1031 exchange is to defer taxes as they continue to operate and grow their investment real estate portfolio. This creates the ability to secure more investment properties that can create stronger asset appreciation over time. In these instances, investors should keep in mind that the high minimum and differing holding times are often more attractive to those looking to grow their real estate holdings.

Understanding the Relationship of Depreciation and the 1031 Exchange
To better gauge the strength of benefits involved in a 1031 exchange, you need to understand depreciation. Depreciation is how general wear and tear on a property affects the overall value of a property. In terms of the 1031 exchange, depreciation represents the percentage of the overall cost of an investment property that is written off due to unavoidable loss of value. This is a non-cash expense.

Depreciation is used to determine capital gains taxes, which considers the original purchase price, any capital improvements made on the property, and depreciation. In instances where a property is sold for higher than its overall depreciated value, investors may need to recapture depreciation. Over time, this can increase, so a 1031 exchange may be necessary to avoid substantial changes in taxable income.

How to Choose a Replacement Property
When it comes to finding a replacement investment property, there are a few things to keep in mind. You need to replace the property with something similar, follow applicable rules, and determine which type of exchange to utilize.

Like-Kind Property
A property is determined to be like-kind based on its inherent nature, not necessarily the quality or value. The primary factor that needs to be similar is that the property needs to be used for investment purposes rather than personal use or resale. Investments can be replaced with vacant land or commercial buildings, but not for items such as artwork, equipment, or finances. To make sure that you take advantage of the 1031 exchange in its full capacity, the replacement property should be either equal or greater value. If it’s a lower value, you will have to pay capital gains tax for the difference—something that is often referred to as cash boot.

Applicable Rules
In conjunction with making sure that a property is like-kind, you need to meet one of three applicable rules: the three-property rule, the 200% rule, or the 95% rule.

The three-property rule allows investors to identify three potential commercial real estate properties for purchase, regardless of their market value.

The 200% rule allows investors to identify as many replacement investment properties as they’d like, if the cumulative value stays below 200% of the investment property being sold.

The 95% rule allows investors to identify as many replacement investment properties as they’d like if the properties acquired are 95% of total value or higher.

Different Types of 1031 Exchanges
There are several different types of like-kind exchanges that can be utilized, each varying with the timing of the exchange and other factors. Some of the more common types of 1031 exchanges include:

Simultaneous Exchanges
A simultaneous 1031 exchange is when the buyer and seller exchange their investment properties at the same time.

Delayed Exchanges
A delayed 1031 exchange, sometimes called a deferred exchange, is when the properties are exchanged at different times. However, the entire transaction needs to be mutually dependent and sometimes, this process can become complex. Delayed exchanges need to be carried out within 180 days.

Built-to-Suit Exchanges
Built-to-suit 1031 exchanges allow for replacement investment properties to be renovated or new construction products, but they must still meet the 180-day requirements. This means all construction needs to be completed by the end of the transaction.

Reverse Exchanges
A reverse 1031 exchange is when an investor purchases new property prior to selling their original investment property. This sometimes requires an exchange accommodation titleholder to avoid problems. The property needs to be identified for exchange within 45 days and purchased within 180 days.

Variations in the 1031 Exchange
There are a few different variations in the 1031 exchange that investors should be aware of: drop and swap 1031 exchanges and tenancy-in-common 1031 exchanges.

Drop and Swap 1031 Exchange
This occurs when certain partners in a business entity want to make a 1031 exchange and others do not. Since partners involved in an LLC only own the interest in the investment property, 1031 exchanges can be carried out on the side of certain transactions. This will require special steps and can get increasingly complex depending on the number of partners involved. If most partners want to make a 1031 exchange, the dissenting investor can choose to receive a percentage of the overall commercial real estate value as proceeds and will need to pay capital gains tax. Thus, they are dropped from the property investment and essentially bought out so the others can move forward with an exchange.

Tenancy-in-Common 1031 Exchange
This variation allows for investors to have factional ownership interest (up to 35 people or entities in total) that’s directly associated with larger commercial properties. This makes it easier for small investors to gain assets in investment transactions and 1031 exchanges. The volume of the investment depends on the percentage of the property they finance. Investors involved in this are called tenants in common.

How to Perform a 1031 Exchange
The first step in performing a 1031 exchange is identifying the investment property you want to sell. Again, this is only applicable for investment real estate. Next, you’ll spend time identifying the investment property you’re interested in purchasing. This needs to be like-kind property, as discussed above. To avoid income tax, engage a qualified intermediary that has zero outside relationships with either seller or buyer involved in the 1031 exchange. Then, determine how much of the original investment sale proceeds will be reinvested into a new property and what loan amounts will need to be replaced. If you don’t reinvest all the proceeds, be prepared to pay some degree of capital gains tax immediately. Make sure that you stay within time parameters—45 days from the original date of sale to identify an interested replacement property and 180 days after sale to purchase the new property. Once finalized, make sure that the IRS is informed by filling out an IRS Form 8824 with your tax return.

For help performing 1031 exchanges, PACT Capital is here. PACT Capital’s teams are qualified to help arrange capital solutions for a successful 1031 exchange. As capital advisors, our team offers a powerful competitive advantage for all your commercial real estate financing needs.

To learn more about 1031 exchanges or commercial real estate financing, email, or call 213-799-PACT (7228) today.


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