When investing in commercial properties, many people use IRC Section 1031 of the US tax code to sell underperforming or high-maintenance properties and trade up to higher-performing properties using the 1031 exchange tax benefit. The 1031 exchange allows deferral of 100% of the federal capital gains taxes as long as you reinvest in one or more like-kind properties, which is any income-producing real estate or raw land.
When coupled with the 25% depreciation recapture savings, investors often gain tens of thousands to millions of extra dollars to reinvest and keep their money working for them. No other investment type offers the opportunity to maximize cash flow, grow your portfolio, and increase your internal rate of return (IRR) quite like commercial real estate (CRE), especially 1031 triple net lease properties.
What is the 1031 Exchange?
Section 1031 of the IRC says you may sell an investment property and exchange it with another “like-kind” property and defer 100% of the capital gains tax on the profits (a savings of up to 20%). There would be no problem exchanging an apartment building for raw land or unimproved property for a high-quality triple net (NNN) lease property and taking the tax break, so long as you invest all the profits into the new property, and the property (or properties) you are buying is equal to or greater in value than the sold real estate.
Keep in mind, the 1031 exchange offers a tax deferral, which means when you sell the newest property, any gains will be taxed as income, unless you sell and utilize the 1031 exchange next time. You can do this indefinitely, as there are no limits on how many 1031s can be used in a lifetime. Additionally, your 1031 properties can be passed to heirs and the pattern can continue. It’s a fantastic way to build a diversified CRE portfolio using money that would’ve been paid in taxes — potentially millions of dollars.
Commercial Property Types You Can Trade in the 1031 Exchange
The exchange can boost wealth by turning underperforming properties or vacant land into high-performing, positive cash-flow NNN properties with long-term leases, often with higher resale value and better returns. You can also trade a fully depreciated property for a more valuable asset that can be depreciated using cost-segregation depreciation.
- Triple net lease properties
- Residential rentals
- Multi-tenant properties
- Gross lease properties
- Vacant land
- Office complexes
- Warehouse/distribution centers
- Industrial properties
- Underperforming commercial properties
- A net lease property coming to the end of the lease term
And here’s an even better perk — when you couple the 1031 exchange with the depreciation recapture tax code, your tax deferral get’s even bigger.
What is Depreciation Recapture or IRC Section 1245?
IRC Section 1245, or depreciation recapture, is how the IRS “recaptures” any depreciation or amortization you’ve taken on your tax return over the years. Depreciation recapture is taken and the profit is taxed as ordinary income when you sell the real estate and realize a profit UNLESS you utilize a 1031 exchange.
Here’s how it works: first, calculate the adjusted cost basis, the length of time you’ve owned the property, and the property’s selling price, which will be used to determine how much you owe in income taxes.
- Your adjusted cost basis is calculated by adding the original purchase price to whatever costs were incurred for capital improvements over the life of the investment. It determines the profit or loss on the property.
- Once you know the adjusted cost basis, subtract the amount that was depreciated over the years until the sale.
- When the sale price of your property exceeds the tax basis or adjusted cost basis, the difference is “recaptured” by reporting it as income, at a maximum rate of 25%. Sadly, even if you did not take depreciation, depreciation recapture is an “imputed” tax, so the tax still applies.
However (here is the BIG IRS gift to help incentivize investing and stimulate economic growth), if you sell your investment property in a 1031 exchange and reinvest the profits from the sale into another investment property within 180 days, you can defer 100% of the capital gains and depreciation recapture taxes on those profits.
What is Capital Gains Tax vs. Income Tax?
To put it simply, income tax is ongoing and paid on the rental income a property generates minus any expenses or deductions, just as if the money was coming from a salary or dividends. By contrast, a capital gains tax is imposed one time — when you sell an investment property. The IRS taxes the profits from the sale when those profits are not rolled into another like-kind property in a 1031 exchange. It’s important to note that most states also impose a capital gains tax and an income tax, in addition to the IRS, so be sure to speak with your tax professional to learn how state and local taxes affect your unique situation.
How to Start a 1031 Exchange
Though we made the 1031 exchange sound simple, it is a complex transaction that requires careful planning, a team of professionals, and strict adherence to the rules, such as how to choose a qualified intermediary (QI) according to the US Treasury Department Guidelines, title requirements, improvement and construction exchanges, understanding of the four different types of reverse exchanges, whether your corporation is utilizing the 1031 exchange, financing, and more.
Therefore, we recommend working with a 1031 exchange specialist and buyer’s advisor who can help you with the entire process, starting before you sell your original property (very important to start BEFORE you sell) and identifying your new 1031 properties, all while representing your best interests throughout the transaction to get you to the closing table on time.
- Before you sell any property, contact a Westwood Net Lease Advisor to start the process.
- Once you’ve worked with your buyer’s advisor to align your goals and choose your 1031 team, it’s time to put your property up for sale.
- Once your property is under contract, it’s time to officially identify the replacement properties you wish to purchase in the exchange.
- From here, your advisor is instrumental in helping you with every step, advocating for you throughout the complex process, and making sure you do not miss that 180-day cut off and end up paying capital gains taxes.
For a step-by-step guide to the 1031 exchange rules and timeline, download our 1031 Exchange Rules & Timeline guide for free.
To Wrap it Up — 1031 Properties are a Smart Way to Build a CRE Portfolio
As you can see, the 1031 exchange is a smart way to defer capital gains taxes, potentially indefinitely, and build a commercial real estate portfolio using the money you would’ve otherwise paid in taxes. Not only does the 1031 help you buy more properties anywhere in the US or purchase higher-quality properties, but it also helps local communities and economies with business growth. The 1031 exchange, when used strategically, can produce worry-free monthly income from a diverse selection of tangible assets across markets, offering returns that won’t fluctuate day-to-day, lowering risk, and increasing your net worth.
To learn more about the 1031 exchange or to get started on the process, reach out to Westwood Net Lease Advisors today, without obligation. Our buyer representation is free and we are passionate about helping investors obtain the right commercial real estate for their goals. 314-997-5227