A 1031 Exchange is a tax-advantaged investment strategy that may allow you to defer capital gains taxes and potentially preserve your income. The IRS has set many rules and stipulations for these kinds of transactions, which are put in place to avoid abuse and maintain the integrity of the exchange.
For example, you cannot just swap any type of property. The assets you exchange must be held for investment or business use. So, can you do a 1031 Exchange on commercial property? Yes, absolutely. Let’s find out how.
Yes, Exchanging Commercial Property Is Allowed
One of the core rules of 1031 Exchanges is that you can only exchange like-kind assets. They must be similar in use, though not necessarily in grade or quality. As long as the two properties are held for investment, trade, or business purposes, then they qualify as like-kind assets.
Commercial real estate is often eligible for §1031 exchange treatment, provided it is held for investment or business use and meets other IRS requirements. These properties are typically used for income-producing or investment purposes, which aligns with §1031 eligibility requirements.
In a few situations, commercial properties may only be partially or completely ineligible for 1031 Exchanges.
- Mixed-use properties with commercial units and personal use units: In this case, only the portion of the sale allocated to the commercial units is eligible for tax deferral under a 1031 exchange.
- When the asset is held primarily for sale: If a commercial property is held by a dealer — such as a developer — with the primary intention of selling it in the ordinary course of their business, it is considered inventory, which does not qualify for 1031 Exchanges.
How a 1031 Exchange Works for Commercial Property
While the IRS rules governing 1031 exchanges apply broadly to real property, commercial transactions often involve additional due diligence, valuation, and coordination among real estate, tax, and legal professionals. Here's a general overview of how the process typically unfolds:
- You conduct market analysis to determine the value of the commercial property and determine if selling aligns with your investment and tax strategy.
- You prepare the property for the sale, working with a 1031 Exchange real estate broker to address issues and market the property on the right channels.
- You negotiate with buyers and arrive at a sales price that’s agreeable to both parties.
- Prior to closing, select a Qualified Intermediary who will hold the proceeds in a compliant manner to avoid constructive receipt.
- Within 45 days of closing, identify potential replacement properties. To achieve full tax deferral, the new property (or properties) must be of equal or greater value, and all net proceeds must be reinvested.
- Within the 180-day timeline, you must identify and acquire a like-kind property that has equal or greater value than your relinquished commercial asset. You can also try other methods, such as entering multiple Delaware Statutory Trusts to diversify your portfolio.
- You close the sale, and the qualified intermediary transfers the funds to the property seller.
1031 Exchange Commercial Property Advantages
Why exchange commercial properties? Here are a few advantages that may help you reach your financial goals.
- Capital Gains Tax Deferral: The primary purpose of like-kind exchanges is to allow investors to delay tax payments. This may enable investors to retain more capital for reinvestment. For estate planning purposes, a step-up in basis can happen for exchanged properties upon the death of the original owner.
- Diversification: A 1031 Exchange allows you to enter new sectors if they’re showing a lot of potential, all without triggering a taxable event upon the sale of your previous property.
- Potential for Increased Cash Flow: As you tap into a promising new industry, investors may achieve a different cash flow profile, subject to the performance of the new asset and market conditions.
Wrapping Up: Like-Kind Exchange Commercial Property
Can you do a like-kind exchange on commercial property? Yes—commercial property may qualify for a §1031 exchange if it is held for investment or productive use in a trade or business, and all other IRS requirements are met.
Because commercial properties are often income-generating and investment-held, they are commonly used in §1031 transactions. However, eligibility ultimately depends on the taxpayer’s intent and use, not solely on the property type.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/terms/l/like-kindproperty.asp
https://www.vts.com/blog/the-6-types-of-commercial-real-estate-properties
https://turbotax.intuit.com/tax-tips/investments-and-taxes/1031-exchange-how-it-works/c998pvsTp
