What is a 1031 Exchange in Commercial Real Estate?

David Cohn
Mar 1, 2021
commercial real estate

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?

What is a 1301 Exchange?

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."

How can a 1031 exchange help you save money?

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.

What types of properties qualify?

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.

Some restrictions to keep in mind

Commercial real estate investors also have to keep in mind additional restrictions before using this strategy. Here are some of the most important ones:

  • You can only perform a 1031 exchange between investment properties. You cannot use it on personal properties. That said, this strategy may apply to former primary residences under specific conditions. Talk to an accountant or commercial real estate lawyer for guidance.
  • The equity in the new commercial property should exceed or at least be equal to the equity in the original asset.
  • This strategy is often applied when exchanging a cheaper property for a more expensive one. If you exchange for something cheaper, there will be tax considerations around the price difference.
  • When you buy replacement property, the name used on the title must be the same name used previously on the original property. For example, if your previous property was titled your LLC, then the same LLC name has to be used on the title of the new property.
  • It's possible to delay the exchange, with a third-party facilitator acting as an intermediary between a prospective future buyer and yourself. This facilitator will prepare the paperwork and hold the proceeds from the sale. Do note that timing restrictions apply, and you must adhere to these deadlines. You have a 45-day window from the day you sell the relinquished commercial property to identify potential replacements. This identification has to be documented. You're also given only 180 days to complete the exchange.

More advantages of 1031 exchanges in commercial real estate

While a 1031 exchange is mainly done to reduce capital gains tax burdens, it offers many other benefits.

  • Bigger buying power: This strategy lets you use money that would otherwise be paid to the IRS to invest in a new commercial property with a higher value. As a result, your overall buying power is improved. A 1031 exchange can be an effective wealth-building tool when used in this manner.
  • Business strategy protection: The absolute deadlines that have to be followed in a 1031 exchange can protect business strategies, ensuring that funds are utilized in the right way.
  • Simplification: You have the option to consolidate several high-maintenance commercial properties into one investment property using a 1031 exchange. Some investors do this to simplify their portfolio and reduce their stress levels.
  • Optimized cash flow: A 1031 exchange can help you move your investments to a property that produces higher dividends while reducing risk.

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.