This article is part of a larger series on Business Financing.
A 1031 exchange allows an investor or business owner to sell a commercial property, acquire another, and defer capital gains taxes in the process. The name refers to section 1031 of the United States tax code.
When a property is sold for cash, the net proceeds incur a capital gains tax. However, if the investor uses the proceeds to purchase another like-kind property, that tax can be deferred. A 1031 exchange can also increase your buying power by allowing you to reinvest the full proceeds of a property sale rather than proceeds that have been reduced due to state and federal taxes.
It’s critical when considering a like-kind exchange that you consult a tax professional to understand the ramifications of the transaction on current and future taxes. This guide will give you a basic understanding of a section 1031 exchange, but it should be used in conjunction with professional tax advice.
8 Steps to Complete a 1031 Exchange
The property purchased in a like-kind exchange should be of equal or greater value unless you use the excess funds to renovate the property.
There are generally eight steps to complete a 1031 exchange. These will usually be done by a professional for you, as they can be complicated. The eight steps include:
- Sell the investment property.
- Give the capital gains to a qualified intermediary, such as an exchange firm or corporation.
- Identify a like-kind property within 45 days.
- Send a duty letter to your qualified intermediary.
- Negotiate with the seller of the like-kind property.
- Agree on a sales price.
- Have the intermediary wire the capital gains to the titleholder or title company.
- Fill out IRS Form 8824.
In addition to avoiding the heavy taxation on capital gains, a 1031 exchange will also allow you to defer your depreciation recapture, which is a procedure for collecting income tax on the amount of depreciation claimed on your property. This could save you as much as 25% on the depreciation of your property.
In addition, you could avoid state taxes with a like-kind exchange. Some states require either the buyer or seller to pay state income taxes, known as state mandatory withholding, when a property is sold. Property transferred in a 1031 exchange can receive an exemption.
Remember that these are deferred taxes because you’ll have to pay them if you eventually sell the new property for cash.
Types of 1031 Exchanges
The three types of like-kind exchanges are:
- Delayed 1031 exchange: This is best for investors and business owners who want to sell their property and defer capital gains by purchasing another like-kind property. This is the most common type of 1031 exchange.
- Construction/improvement 1031 exchange: This is best for investors who want to buy a fixer-upper of lesser value and use the remainder of the money for renovations. The renovations must be finished within 180 days or they could be subject to capital gains tax.
- Reverse 1031 exchange: This is best for investors and business owners who want to buy a new like-kind property before selling their existing property. The reverse 1031 exchange is the least common type of exchange; it’s used when the buyer is looking to purchase a property when the market is down and sell an existing property when the market spikes. This is difficult to time in the limited time window allotted by section 1031.
1031 Exchange Rules
There are five 1031 exchange rules you need to know. Again, consult your tax professional for more details on how these rules apply to your transaction.
- Like-kind property rule: The property purchased must be “in the same nature and character, even if they differ in grade or quality.” It’s a very vague rule, which is why your tax professional can help you make that determination.
- Property identification timing rule: Upon closing the initial sale of your property, you have up to 45 days to identify a like-kind property by giving a letter to a qualified intermediary. It’s possible to identify up to three properties. You can go over three, but the total value of those properties cannot exceed 200% of the value of the property sold.
- Property purchase timing rule: You have 180 days from the sale of your property to purchase your new property. The deal must close within 180 days, with the capital gains wired to the titleholder or title company handling the closing.
- Property value rule: To defer all capital gains and avoid paying the full capital gains tax, you’ll need to reinvest your full equity in a new property of equal or greater value. If there’s a difference that isn’t invested in improvements, it’ll be taxable at the capital gains tax rate.
- Holding time rule: While there’s no strict rule on the time you need to hold your initial property, the IRS typically likes to see property held for more than one year. The IRS wants properties to be held as long-term investments rather than fix-and-flip properties.
Who a Section 1031 Exchange Is Right For
A like-kind exchange is most often used by real estate investors, especially when selling one rental property and acquiring another. Before beginning the process of getting a small business loan for investment property financing involving a like-kind exchange, consult your tax professional and legal experts to make sure all of your business interests are protected. Also, be sure to check out the latest commercial real estate rates before purchasing a new property.
Section 1031 exchanges can also be used by small business owners looking to sell a business and acquire a new one. A like-kind exchange can be used because a company is made up of real property, like real estate and assets. It cannot be used for intangible concepts such as goodwill and reputation. A 1031 exchange involving businesses is best used when the two businesses have similar property and equipment, such as one restaurant for another one.
Companies That Offer 1031 Exchange Help
In addition to your tax and legal professionals, you should enlist the help of a 1031 exchange firm or intermediary to assist with the process.
A 1031 exchange firm’s sole purpose is to know the ins and outs of IRS requirements with like-kind exchanges. The firm will serve as your intermediary in the process. Equity Advantage is an excellent example of a 1031 exchange firm that helps real estate investors and business owners.
A 1031 exchange intermediary is a company that just facilitates 1031 exchanges. There’s no requirement that these companies be licensed, insured, or bonded, so be sure to research any company thoroughly before signing on with them. An excellent example of a like-kind exchange firm is 1031 Corporation. The company specializes in reverse and improvement exchanges. 1031 Corporation can also help you find suitable properties to complete your exchange.
Example of a 1031 Exchange
Here’s why a 1031 exchange can be critical to your business: it not only defers capital gains taxes, but it can increase your buying power in a new property.
In this example, you have sold a property for $1 million and received net proceeds of $500,000, which is also a capital gain.
- Without using a 1031 exchange, the $500,000 will be taxed as much as 40% (a combination of federal capital gains, depreciation recapture, state capital gains, and net investment income tax). This leaves you just $300,000 to invest in a new property. If you assume a 25% down payment on a new property, the maximum you could purchase in replacement is a property worth $1.2 million.
- However, by using a 1031 exchange, you can reinvest the entire $500,000 in a new property. With 25% down, the new property you can purchase with the full $500,000 as a down payment is now $2 million.
By using the 1031 exchange, not only did you defer your tax burden, but you can purchase a property worth $800,000 more with the same net proceeds from the previous sale.
A 1031 exchange is an IRS tax code that can help you save money on selling a commercial or investment property. It enables you to defer capital gains tax so long as the acquired property is like-kind to the one sold. Using a 1031 exchange can also increase your buying power for new commercial properties.
This can be a highly complex process. In addition to the information in this guide, you should have your tax and legal professionals, along with a 1031 exchange firm or intermediary, assist you with any attempt to use a like-kind exchange.