Smart Investing Using a 1031 Exchange

flowchart of how a 1031 exchange worksWhat is a 1031 Exchange?

A 1031 Exchange is a nothing more than a tax deferment. It is used as a strategy by successful commercial real estate investors. Real estate investors get to defer their payment of capital gains taxes on any investment property that they sell if they turn around and purchase a “like-kind” property of equal or greater value in a certain period of time.

Example: In general terms, the initial property is valued at $1M and you have a $500,000 mortgage on the property. A “like-kind” property would need to be $1M in value or more, and the $500,000 of equity would need to be invested into the replacement property.

Who Can Use 1031 Exchanges?

1031 Exchanges can only be used by real estate investors and business owners, not residential home owners. There is some flexibility in how it can be used that makes this one of the best strategies for many investors. Keep reading!

Are There Different Types of Exchanges?

Sure. There are four different types:

Simultaneous Exchange – Just as it sounds, this exchange results in closing on both properties on the same day. If the planets align for you in this way, great; however, this hardly ever happens.

Delayed Exchange – This is probably the most common type of exchange. An investor has 45 days to identify three potential properties and 180 to purchase the replacement.

Reverse Exchange – This type is less likely to happen as you actually buy the replacement property first and sell the initial property later. Maybe you’ve found the perfect investment before your initial property is sold. This is fine if you have the cash or a cooperative lender. Since you cannot own both properties at the same time and still get the benefits of a 1031 Exchange, you need an accommodator to take title to the new property temporarily, until you sell the existing one.

Construction/Improvement Exchange – This comes in handy when the replacement property is ideal, but has a lower value than the initial property – remember “like-kind” properties are the first rule of any 1031 exchange. Solution? Use the remainder of the proceeds from the sale of the initial investment to somehow improve the replacement property. This can be new construction, such as an addition, or it can be in the form of improvements to upgrade the current structure. Like a reverse exchange, this type of exchange requires an accommodator to hold title to the new property while improvements are added.

What are the Rules?

Rule #1

modern apartment building on blue sky background

Okay, let’s say it one more time – “like-kind” properties are the only properties that qualify for a 1031 Exchange. While you can’t exchange an investment in large machinery (construction equipment) for, say, a multi-family complex, all real property is considered “like kind.” You can:

Lastly, U.S. properties can only be exchanged for properties in the United States. Foreign investment properties can only be exchanged for foreign property.

Rule #2

The taxpayer on both properties must be the same. That being said, there is some flexibility with entities. For example, you can sell a property in your individual name and buy in a single-member Limited Liability Company (LLC) as long as you are the only member.

Rule #3

The investor has 45 days from closing on the initial property to identify up to three potential replacements.

Rule #4

The investor must purchase a replacement property by the earlier of (1) 180 days of closing on the initial property, or (2) the due date for filing their tax return for the year the initial property was sold. However, an investor could file for an extension on their tax return to get the full 180-day exchange period.

Rule #5

Investment or business properties are the only types of property that qualify. Residential, owner-occupied homes do not qualify.

Rule #6

The replacement property (and equity) must be greater or equal value than the initial property in order to have a fully tax-deferred exchange.

Rule #7

As the investor, you must not receive the “boot.” WHAT??? This just means if you keep any of the proceeds of the sale of the initial property, you will be taxed on that amount.

Example: $1M property is exchanged for one that is $750,000. You would need to pay capital gains tax on $250,000.

investment terms associated with 1031 exchangesIs Now the Time to Invest?

If you are a savvy investor who follows the Commercial Real Estate market for prime growth opportunities, 1031 Exchanges can prove to be a valuable strategy for you. The biggest downfall of 1031 is that you risk a reduction in the depreciation basis on the replacement property if you don’t understand the market climate.

When looking for a replacement property, be sure you’re entering a market that has good potential for growth in order to avoid this pitfall. Raleigh and the surrounding areas are hot markets, boasting great opportunities for growth, particularly in the multi-family and warehouse/flex markets.

Partner with Craft Commercial and Achieve Your Investment Goals

Trust the seasoned professionals at Craft Commercial to help you successfully navigate the complexities of a 1031 Exchange. We are a locally-owned real estate company that has served the Triangle for over 30 years. Contact us at 919-446-5000 or info@craftcommercial.com.

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