Section 1031 of the Internal Revenue Code offers a powerful tax strategy for commercial real estate investors. It allows an investor to sell a commercial property and defer paying capital gains taxes by reinvesting the proceeds into a like-kind property of equal or greater value.
Before using this strategy, it is important to understand the tax considerations involved in a 1031 exchange.
Definition of like-kind properties
The IRS defines like-kind properties as those of the same character or nature, even if they are of different grades or quality. Most real estate qualifies as like-kind as long as it consists of the same type of investment. For purposes of Section 1031, most commercial property is kind to other commercial property.
Tax deferral, not elimination
A 1031 exchange does not eliminate capital gains tax altogether. It merely defers the tax until a buyer purchases the replacement property in a taxable transaction in the future. However, the seller may be able to use Section 1031 again in that later transaction and continue to defer the tax. And, deferring taxes generally creates significant benefits for investors.
Benefits of tax deferral
Tax deferral allows investors to keep more capital working and can compound returns over time. It lets real estate owners acquire replacement properties without paying heavy upfront taxes that deplete equity. Ultimately, these exchanges can cause greater wealth accumulation.
Strict rules
To execute a 1031 exchange and enjoy full tax deferral, investors must adhere to strict rules and timelines set by the IRS. For example, they have 45 days after selling the relinquished property to identify one or more potential replacement properties in writing. They have 180 days to complete the acquisition.
Qualified intermediaries
Due to the complexity of the process, many investors work with qualified intermediaries to facilitate 1031 exchanges. A qualified intermediary holds the sale proceeds in escrow and handles the entire process according to IRS regulations to help ensure full compliance.
Commercial real estate investors considering a 1031 exchange should start planning and exploring options well in advance of any property sale. Early preparation increases the chances of finding and closing on a suitable replacement property within the allowed timeframe.