Investing in commercial real estate is a powerful move, but when disposition comes, the tax liability from capital gains can be substantial. Thankfully, many strategies are available to help you preserve more of your capital.
Is using a 1031 Exchange for commercial real estate a good strategy for tax deferral? The answer is yes. In fact, the like-kind swap is one of the primary avenues used by many investors to delay tax liability. Realized 1031 shares an article explaining how this works and how you can execute one yourself. Keep reading to learn more.
1031 Exchange Commercial Real Estate Tax Deferral
In a traditional sale or disposition, investors in commercial real estate will be liable to capital gains taxes during the year of the sale. These costs eat into your profit, especially if you’re within the higher tax brackets.
1031 Exchanges are a framework based on Section 1031 of the Revenue Code. Instead of a sale, there’s a swap of two or more “like-kind” properties. The process avoids the creation of a constructive receipt, and by extension, an official sale. As a result, the IRS doesn’t recognize gains or losses. Your capital gains tax payments will be delayed until a taxable event occurs, such as the sale of the replacement asset.
IRS 1031 Exchange Rules for Commercial Property
The IRS imposes strict rules and requirements to defer capital gains tax on commercial property. These regulations prevent abuse and ensure that the exchange follows the defined framework that differs from a standard taxable sale.
- Like-Kind Requirement: Only properties similar in nature or like-kind are allowed for exchanges. In other words, you can only swap two assets held for business or investment use. Commercial properties are almost always qualified since they are unambiguously utilized for income generation.
- Qualified Intermediary: The IRS requires the involvement of a qualified intermediary (QI). Not only is this the entity that oversees the entire exchange, but it also holds the proceeds from the sale of the relinquished property to prevent your direct control.
- Deadlines: The entire exchange must happen within a 180-day timeframe, with the initial 45 days dedicated to identifying prospective replacement properties.
- Reinvestment of All Proceeds: The replacement asset must be of equal or greater value than the relinquished property. This allows you to reinvest all proceeds, as any leftover cash or unmatched debt can result in a taxable boot.
The Exchange Process
How does the exchange happen? Here’s a step-by-step guide that remains compliant with IRS guidelines.
Step 1: Planning and Engaging With QI
The first step is to determine whether a 1031 Exchange is the ideal strategy for your next venture. If it is, you’ll want to find and begin working with a QI to oversee the exchange.
Step 2: Selling Relinquished Asset
This step follows a similar process to a traditional sale. However, the funds must be transferred from the buyer to the QI, never directly to your accounts. After closing, the 180-day timeline begins.
Step 3: Identification Period
The first 45 days are dedicated to identifying up to three properties or more if you follow the 200% rule. You’ll need to submit the details to your QI as part of the identification process.
Step 4: Negotiations and Closing
You purchase the replacement property following traditional routes. Only this time, the QI transfers the funds to the seller instead of you taking care of the payment. After closing, the exchange is officially over. Report the gains deferred and other details using Form 8824.
Commercial Real Estate 1031 Exchange Benefits
The tax-deferral benefits afforded by 1031 Exchanges go beyond preserving more of your profits. First, being able to preserve more of your capital allows you to access higher-value assets that are more likely to generate steady income. Plus, it’s much easier to restructure your portfolio since you won’t have to think about tax payments when entering new markets or disposing of underperforming assets.
When paired with Delaware Statutory Trusts (DSTs), 1031 Exchanges provide passive income and enhanced diversification. In summary, 1031 Exchanges for commercial properties open a host of advantages that can help you optimize cash flow and build long-term wealth without the immediate burden of capital gains tax liability.
Final Thoughts: 1031 Exchange Tax Deferral for Federal Properties
For high-value commercial real estate sales or assets with significant appreciation, 1031 Exchanges offer a way to delay capital gains tax payments and preserve your equity. As long as you follow IRS rules and processes, you can enjoy this benefit and leverage your gross proceeds to secure higher-quality, institutional-grade assets that better align with your long-term financial goals.
Sources:
https://www.nar.realtor/section-1031-like-kind-exchange
https://www.delawareinc.com/blog/what-is-a-delaware-statutory-trust/
https://nstp.org/memberarea/federaltaxalert/2023/what-is-boot-in-a-1031-exchange
