If you’re an investment property owner, and are considering selling to buy a different investment property, you may be able to take advantage of a 1031 tax-deferred exchange.
A 1031 exchange — also known as a “like-kind” exchange — allows you to defer capital gains tax on the sale of your investment property when you reinvest the proceeds into a similar investment property.
Let’s take a look at how this exchange works and the benefits of a 1031 exchange for investors.
What Is a 1031 Exchange?
The 1031 exchange gets its name from the United States Internal Revenue Code Section 1031, which states, in part, “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
In other words, a 1031 exchange allows you to defer the payment of capital gains tax on the sale of your investment property, provided that you reinvest the proceeds from the sale into like-kind property of equal or greater value within a certain period of time.
While those capital gains taxes will eventually have to be paid (as this is a tax deferral, not an exclusion), a 1031 exchange is a useful tax strategy to preserve the value of your investment portfolio.
There are several types of 1031 exchange, with the most common being:
- Simultaneous exchange: The replacement property and relinquished property close on the same day.
- Delayed Exchange: The property owner sells the original property before acquiring replacement property.
- Reverse Exchange: The property owner acquires a replacement property before selling the exchanged property.
- Construction/improvement Exchange: Allows the property owner to use the exchange equity to make improvements on the replacement property.
What Is “Like-Kind” Property?
To qualify as an exchange, both the sold and newly purchased properties must be qualified as “like-kind” properties, and the transaction must be structured as an exchange. “Like-kind” refers to the nature or character of a property, not its grade or quality. It can include any real estate held for investment or commercial purposes, whether improved or unimproved, such as:
- Agricultural Land
- Apartments
- Hotels
- Leased Properties
- Manufacturing
- Mixed Use
- Office
- Residential
- Retail
- Tenant in Common (T.I.C.) Properties
- Vacant Land
Qualified Intermediary
One element of a 1031 exchange that differs from a typical real estate transaction is that the sale proceeds must run through a qualified intermediary.
Section 1031 states that because proceeds received from the sale of a property remain taxable, those proceeds must be transferred to a qualified intermediary rather than the seller of the replacement property. From there, the qualified intermediary transfers the proceeds to the seller of the replacement property.
The qualified intermediary can be a person or company who has no other formal relationship with either the seller or buyer of the property in question.
Benefits of a 1031 Exchange
Tax Benefits
One of the biggest benefits of a 1031 exchange is the ability to defer capital gains taxes from the sale of a property.
This leaves more of your money available for investment and allows for greater wealth and asset accumulation vs a traditional property sale. It keeps your money working for you, rather than being paid out in taxes.
Reset the Depreciation Schedule
A 1031 exchange also gives you the opportunity to reset your asset depreciation schedule, further reducing the amount of income taxes you pay due to depreciation. Here’s how that works:
A property owner is able to write off depreciation of their asset to compensate for wear and tear, aging, or other deterioration of the property. The IRS recognizes the depreciable time period for an investment property as 27.5 years. Every year for 27.5 years, the value of your building divided by 27.5 can be deducted from ordinary taxable income.
When you participate in a 1031 exchange, you can elect to reset the depreciable amount of your investment property to a higher value, giving you a greater tax benefit. (Check with your CPA for details.)
Diversify Your Portfolio
A 1031 exchange can be used to diversify your investments across different markets or asset types, reducing your potential risk.
You may choose to divide a single property into several assets, for example. And as like-kind exchanges aren’t constrained by state lines, you could decide to divide your investments across multiple states. Or, you could use part of your investment to get your foot in the door of an up-and-coming market.
With a 1031 exchange, you have options.
Build Wealth
You can also use a 1031 exchange to trade up to a property (or several properties) with higher returns. This allows you to use the built-up equity in an existing property to acquire a better-performing asset without paying capital gains taxes on the sale.
This means you can leverage more of your existing equity to purchase a new property. More equity can help decrease your loan-to-value ratio when purchasing a higher value property. And a 1031 exchange can be repeated indefinitely, helping you to increase your purchasing power and build wealth.
Reduce Maintenance Responsibilities
The downside of owning investment properties is the cost and time commitment required to maintain them. If you’re looking to trade existing properties for ones with less responsibility, you can use a 1031 exchange to do so.
If you own several properties with extensive maintenance costs or intensive management requirements, you can utilize a 1031 exchange to swap them for more passive investments. In this case, a 1031 exchange can not only save you money, it can also help you reclaim your time.
Work With the APPRO and CERRON for Your Next Real Estate Investment Purchase
We hope this blog helps you more fully understand the benefits of a 1031 exchange and how you may be able to utilize this tax-saving tool for your next investment property purchase.
When it comes to real estate investing, choosing to utilize a 1031 exchange is only one of many considerations. As you navigate the process of purchasing your next commercial property, the team at APPRO Development and CERRON Commercial Properties would love to help. We are well-versed in all the options available for real estate investors — including the 1031 exchange.
Contact us today to learn how we can help with your next commercial property investment.
Disclaimer: It is advisable to consult with your accountant or tax advisor to review your particular transaction and determine if a 1031 exchange is right for you.