Savvy commercial real estate investors use 1031 exchanges to build wealth. But what is it exactly, and how can it be applied to your case?
In commercial real estate investing, doing a 1031 exchange means swapping one commercial investment property for another in a way that allows the deferment of capital taxes that otherwise have to pay at the time of sale.
The nickname "1031 exchange" refers to the rules under Section 1031 of the US IRS tax code. You might hear the term used as a verb in commercial real estate conversations, as in, "You can 1031 that office building for another property."
A 1031 exchange essentially allows commercial real estate investors to delay paying capital gains on a property sale.
You can technically use a 1031 exchange throughout your career to buy bigger or better commercial properties without paying capital gains taxes until the end.
It's an investing strategy that can use to accumulate wealth. As you already know, capital gains taxes can dramatically cut into a deal's profit margins.
The tax imposed on profits that come upon selling a commercial property is a huge tax burden that can hinder profits and is one of the investors' highest costs.
In theory, if you purchase a property for $2 million and sell it for $2.5 million, then the financial gains subject to tax would amount to $500,000.
Luckily, you can use 1031 exchange to minimize the impact of taxes on the deal. You can use that $500,000 to buy one or more investment properties without having to pay taxes at the time of the sale.
You can use the proceeds to immediately fund the purchase of new commercial land or building that may appreciate and generate cash flow, growing your portfolio.
How is this legal? Look at it this way. Using a 1031 exchange essentially means that any gains made from selling a property are reinvested in a similar property.
The investor technically does not receive the sales proceeds in a way that any taxable money is distributed.
At this point, the investment changed into a new commercial property. It's possible to do a 1031 exchange with a single property or sell multiple properties in exchange for one or more commercial properties. If used correctly, a 1031 exchange can be employed multiple times.
There is no limit on how frequently you can use it.1031 is legal for as long as you follow the rules and regulations that apply to it.
It's important to have accounting professionals assist you when proceeding with an exchange to ensure that you are not violating any laws.
Also, keep in mind that it's impossible to avoid capital gains taxes completely. A 1031 exchange delays the payment of these taxes until the property/properties are liquidated or when the investor passes on.
You can exchange only "like-kind" properties in a 1031 strategy. But what exactly is it like-kind? The jargon used in the tax code is somewhat vague.
Contrary to popular belief, the two properties don't have to be exactly alike. The actual regulations as applied are surprisingly liberal.
For example, it's possible to exchange raw land for an apartment building or a strip mall for a ranch in most cases.
Of course, not all exchanges are allowed.
This is why it's important to work with a professional if you're thinking about using a 1031 exchange so you can avoid the potential pitfalls.
Commercial real estate investors also have to keep in mind additional restrictions before using this strategy. Here are some of the most important ones:
While a 1031 exchange is mainly done to reduce capital gains tax burdens, it offers many other benefits.
As you can see, a 1031 strategy can offer immense benefits—but only when executed correctly.
Many caveats may trap newer commercial real estate investors. Make a mistake, and you may have to pay taxes on the entire sale. This is why it's important to work with experts.
Disclaimer: The information in this blog does not constitute financial or legal advice. It is designed to provide an overview of how 1031 exchanges can be used in commercial real estate so that you have the basic information you need when you explore your options with a tax expert.