Look no further than the Internal Revenue Code (IRC) 1031 to find a golden opportunity to sell certain real estate assets without paying capital gains taxes. Under Section 1031 of the IRC, a 1031 exchange allows you to invest profits from the sale of one commercial property into a similar or “like-kind” and often more valuable property within 180-days, and possibly defer the taxes indefinitely.
In effect, your government is giving you an interest-free loan! Keep reading for the basics of the tax code and 1031 exchange timeline and start thinking about diversifying your investment portfolio with tax-free commercial real estate.
What Types of Properties Can be Exchanged?
According to the IRS’s “like-kind” guidelines, all property purchased for investment purposes is considered similar in nature. Therefore, you would have no problem exchanging an apartment building for raw land or unimproved property for commercial property and taking the tax break, so long as you invest 100% of the capital gains and the property you are buying is equal to or greater in value. You can also use the 1031 exchange on certain capital equipment such as very large machinery, like a crane or an assembly line component.
A Few §1031 Rules & Timing
- The property you sell and the property you buy must be used in a trade, business, or for investment purposes.
- The proceeds from the sale of your original property must be handled/held by a qualified intermediary and not by you or someone representing you. This is usually a title insurance company.
- We recommend choosing the property you wish to buy and a non-partial intermediary, such as a title insurance company, before you begin the 1031 process to avoid a time-crunch.
- You may identify three or more properties as possible replacements for your old property.
- If you choose to identify more than three properties, their combined value cannot exceed 200% of the value of your old property.
- You must purchase at least 95% of the combined value of all the property you list as replacements for your old property.
- The level of debt on the new property must be equal to or higher than the level of debt on your old property.
- You have 45 days after you sell the old property to identify or buy the new property or properties you intend to purchase.
- You must own your new property within 180 days of the sale of the old property or by the due date for your tax return for the year in which the transfer of the old property takes place, whichever arrives first.
- Any profit from the original sale that is not reinvested in the new property will be taxed.
The 45-Day Rule – Identify
It is advisable to already know your replacement properties and intermediary before commencing with the 1031 process so that you don’t end up in a time crunch. The IRS only gives you 45 days after the sale of your old property to either complete the purchase of a new property or legally identify the new property you intend to purchase as part of your 1031 exchange.
If you have not completed the entire purchase in the 45-day timeframe, then you must provide your chosen intermediary, usually a title company, with the list of prospective properties within 45 days, even if the forty-fifth day is on a Sunday or holiday. This list must be in writing and note each property’s address and legal description. It can include up to three properties without regard to total cost and more than three properties if their combined value is less than twice the value of the property you sold.
The 180-Day Rule – Complete the Sale
You must complete your 1031 exchange within 180 days of selling your old property by purchasing one or more of the properties on your list within the 45 days of the sale of your old property. If you choose more than three properties, they cannot exceed 200% of the value of your old property. You cannot buy property as part of the exchange that is not on the 45-day list.
The only exception to the 180-day rule is that the sale may be completed by the due date of your income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier. The exchange must be completed in 180 days total, not 45 days plus 180 days.
Benefits of Using the §1031 Tax Code
Besides potential indefinite tax deferral on commercial property and equipment sales, other great benefits to using the IRC §1031 exchange include:
- Trading up from a high-maintenance property to a low-maintenance property (like going from an apartment complex to a triple-net lease investment).
- Diversifying your holdings by exchanging one property for two or three.
- Relocating your property investment to a more promising part of town or area of the country that is getting ready to boom.
- Bolstering your real estate investment portfolio.
More 1031 Exchange Considerations
Though this tax code has been simplified for this article, there are many intricacies and other laws that need to be considered and followed, such as how to choose an intermediary according to the US Treasury Department Guidelines, title requirements, improvement and construction exchanges, four different types of reverse exchanges, whether or not your corporation is utilizing the 1031 exchange, and financing.
To learn more about the depth of the process and the 1031 exchange timeline, download our eBook: Westwood Net Lease Advisors’ Exclusive Guide on Triple-Net Leases And 1031 Exchanges.
“My company had outgrown its urban manufacturing plant and the building had depreciated to almost nothing. My CPA suggested that I call Westwood Net Lease Advisors who advised me on several creative ways to use a 1031 exchange. With Westwood Net Lease Advisors help we purchased land in the suburbs and built a new facility. After we moved in, we put our old facility on the market and sold it under a reverse construction exchange. This little piece of advice saved us $1.3 million in taxes.” – Jacob Freedberger, New York
To Wrap it Up – Exchange Properties Tax-Free
Section 1031 of the IRC allows you to “exchange” profits, or capital gains, from the sale of one commercial property into a similar investment property – tax-free – within 6 months of selling your old property. Westwood Net Lease Advisors advocates using the 1031 exchange for triple net lease properties to maximize your investments and diversify your portfolio. Our expert advisors can help you with the details and make it simple to utilize this tax law for your next investment. Contact us today for a no-obligation consultation. 314-997-5227