One of the primary reasons people choose to invest in real estate is because it’s a highly tax-advantageous industry. There are many reasons why this is the case, but one tool, in particular, helps investors buy commercial real estate: the 1031 exchange.
In theory, the concept itself is simple: Reinvest the proceeds from the sale of a business or investment property into a like-kind investment to defer paying capital gains tax. Doing so increases an investors’ purchasing power because he can use 100% of his current property equity to invest in a replacement property, such as a higher value industrial or commercial asset. Using a 1031 exchange is an excellent tool for investors looking to grow their real estate portfolios.
In reality, 1031 exchanges are quite complex. Section 1031 of the Internal Revenue Code (from which the term gets its name) contains many nuances that can be daunting to a novice investor.
The Delayed Exchange
The Delayed Exchange is the most common type of 1031 exchange. A Delayed Exchange is one in which a third party, known as a “Qualified Intermediary” (QI), facilitates the selling of one’s property and assures that proceeds are used for the acquisition of another like-kind property. Upon the QI’s receipt of money from the sale of a property, an investor has 45 days to formally identify which replacement property (or properties) he wants to buy.
The “exchange period” is an important deadline investors must monitor while doing a 1031 exchange. An investor only has 180 days from the date he closes on the relinquished property to close on the replacement property, otherwise known as the exchange period. The transaction must be settled within 180 days for the Delayed Exchange to be considered successful.
We’ll cover other types of 1031 exchanges in a future article (stay tuned!).
Defining a “Like-Kind” Investment
The IRS considers “like-kind” property as any property used in a trade or business as an investment. It generally refers to real estate: single family, multifamily, commercial, retail, industrial, condos, hotels, and raw land are all examples. It also applies to personal property used for business purposes, such as vehicles, airplanes, office furniture, business equipment, and even livestock. Private property can be traded directly through the Personal Property Exchange, though personal property is most often traded in conjunction with some form of real estate.
The term “like-kind” can be somewhat misleading. An investor who sells an apartment building is not required to purchase another apartment building. He can exchange that apartment building for raw land or a strip mall, if he so chooses—as long as that type of property is eligible for exchange.
Stocks, bonds, securities, certificates of trust, interests in partnerships and business inventory intended for sale are examples of property that cannot be sold using 1031 exchanges.
Investor Sam is the owner of a 12-unit multifamily apartment building in Oakland that has appreciated almost three-fold since he purchased it 20 years ago. Given this increase in value and Sam’s desire to invest in a property in San Jose with his profits, he decides to sell the property. Before he enlists a real estate broker to market the building, Sam calls his long-time CPA to evaluate the tax considerations of selling the property.
Over the 20 years that Sam has owned the building, his net adjusted basis has decreased significantly due to the depreciation he has recognized.
Original Purchase Price: $1,500,000
Capital Improvements: $50,000
Depreciation Taken: ($1,000,000)
Net Adjusted Basis: $550,000
Sam’s CPA tells him that his capital gain and resulting tax liability will be high because of the property’s strong appreciation and low net adjusted basis. A potential sale might look like the following:
Sales Price Today: $4,250,000
Net Adjusted Basis: ($550,000)
Closing Costs: ($200,000)
Capital Gain: $3,500,000
Sam will be able to claim $1 million in depreciation recapture (generally taxed at 25%). Since Sam is in the highest tax bracket, the remaining $2.5 million in capital gain will be taxed at a long-term federal capital gain rate of 20% + 3.8% for the Medicare surtax. The State of California’s capital gains tax eats away another 13.3%, and now Sam’s potential tax liability looks something like this:
Capital Gain: $3,500,000
Depreciation Recapture: ($1,000,000)
Net Capital Gain: $2,500,000
Tax on Depreciation Recapture (25%): ($250,000)
Federal Capital Gains Tax (20%): ($500,000)
Medicare Surtax (3.8%): ($95,000)
State of California Capital Gains Tax (13.3%): ($332,500)
Total Tax Liability: $1,177,500
However, Sam doesn’t own the property outright. He still has an outstanding loan balance in the amount of $600,000. So if he were to sell for $4,250,000 he’s only walking away with $3,450,000 from the sale once he pays off his loan and pays for his closing costs. After he pays taxes on those proceeds ($3,450,000 - $1,177,500) he’s really only left with about 65.8% of his sales proceeds, or $2,272,500.
Sam’s CPA also reminds him that if he were to pay the capital gains taxes and reinvest his after-tax proceeds into a new acquisition (assuming a 70% loan-to-value ratio), his purchasing power weakens. Let’s look at the comparison between using a traditional sale versus a 1031 exchange:
After-Tax Sales Proceeds: $2,272,500
Maximum Purchase Price of New Property (70% LTV): $7,580,000
1031 Exchange Tax-Deferred Sales Proceeds: $3,450,000
Maximum Purchase Price of New Property (70% LTV): $11,500,000
Purchasing Power Advantage with 1031 Exchange: $3,920,000
Sam decides it’s time to sell his 12-unit multifamily in Oakland via a 1031 exchange.
There are many benefits to utilizing a 1031 exchange: you can defer paying capital gains tax, increase purchasing power when investing in another like-kind investment, and accumulate a more extensive portfolio of real estate that can be passed down to heirs. Savvy real estate investors use 1031 exchanges all the time.
Contact your local commercial real estate broker to learn more about how a 1031 exchange can help you “trade up” into higher-value commercial real estate.