What Is a 1031 Exchange?

As commercial property investors can attest, the transaction costs of buying and selling property can sometimes make or break the profit that might come from a transaction. Most significant among these costs are capital gains taxes assessed on any profit from a property sale. The section 1031 exchange rule permits investors to defer capital gains taxes on the sale of an investment property, if another qualifying investment is made within the time guidelines specified in the rule.

What Is a Section 1031 or like-kind Exchange?

Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031) provides that an owner of investment property can defer capital gains taxes if the individual sells the investment property and reinvests the proceeds from the sale within certain time limits in a property or properties of like-kind and of equal or greater value.

Several restrictions apply to Section 1031 exchanges. First, only investment or income-producing assets qualify. This means that personal properties, such as a primary residence or vacation home, do not qualify. Second, both the old and replacement properties must be of a like-kind. Third, the value of the new property must be equal to or greater than the value of the property being sold. 

Importantly, the transaction must be managed by a qualified intermediary, as defined by the tax code. Once the sale of your property occurs, the intermediary receives the sale proceeds. The property seller must designate the replacement property, in writing, to the intermediary within 45 days. Buyers can designate up to three properties so long as they eventually close on one of them. The buyer then has 180 days from the date of the original sale to close on the replacement property. 

What Is A Property Of Like-Kind?

A property is of “like-kind” if it is of the same nature or character as the property being exchanged, even if the two properties differ in grade or quality. Real estate properties generally are of like-kind, regardless of whether they’re improved or unimproved — this means that an apartment building can be exchanged for farmland or a vacant lot, for example, so long as the replacement property is of equal or greater value. 

International investors should take note, however: if the property being sold is located within the United States, the replacement property must also be in the United States to be considered a property of like-kind. 

What Properties Qualify For A 1031 Exchange?

Not every type of property is eligible for a 1031 exchange. As noted above, a primary personal residence will not qualify. Nor will property held for sale by an investor for the sole purpose of resale, such as a developer’s inventory or a house being “flipped.” To qualify, a property must be held for productive use in a trade or business, or for investment, including such properties as an apartment building, a vacant lot, a commercial building, or even a single-family residence that is not the owner’s primary residence. 

Although prior versions of the rule permitted section 1031 exchanges of some kinds of personal property — such as machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property — the rules were changed in 2017. From 2018 on, Section 1031 has applied only to exchanges of real property and not to exchanges of personal or intangible property.

Could there be additional restrictions in store? The Biden administration has recently signalled its interest in eliminating the right to defer taxes on property gains over $500,000, according to a report by CNBC — though it remains to be seen if this plan will take shape in the months ahead. 

The Role Of The Qualified Intermediary

A qualified intermediary is a person or company that facilitates the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the like-kind replacement property. Under Section 1031, any proceeds received from the sale of a property are taxable unless they are transferred to the qualified intermediary, rather than the seller of the property. The qualified intermediary, in turn, transfers the funds to the seller of the like-kind property. 

The qualified intermediary, in addition to holding the funds in the exchange, also ensures that the exchange meets the requirements of the law and prepares the documentation the seller will need for tax purposes. Selecting an unscrupulous or nonqualified intermediary can have devastating financial consequences. Make sure that you are choosing the right qualified intermediary by talking with the commercial real estate experts at Landtrust Title.

Why Pursue a 1031 Exchange?

It may seem counterintuitive to pursue an exchange of similar properties. After all, investment properties of like-kind and similar value are essentially fungible; why incur transaction costs to trade one for another? 

One reason is depreciation. Depreciation is the accounting rule that allows an asset’s value to be written off over time, accounting for wear and tear and the slow decline of an asset’s value. For property, depreciation is calculated as the cost of the property divided by the property’s useful life. Each year, a certain percentage of the cost of the property is deducted from the owner’s tax liability.

This formula for depreciation doesn’t account for assets that might increase or hold value over time; in many cases, properties may increase in value over time as the result of a hot property market or inflation. When a property is sold, the seller’s capital gains taxes are calculated based on the property’s “net-adjusted basis” — that is, the property’s original purchase price, plus any capital improvements made to the property, minus any depreciation written off over time.

If a property sells for more than its net-adjusted value, the seller may have to “recapture” the depreciation, or pay taxes on some of the depreciated value that had been previously written off.

Depreciation is written off according to the schedules in IRS Publication 946 — as time goes by, the total depreciation an investor has written off increases. Since the relative amount of the depreciation recaptured increases with time, a seller may choose to pursue a 1031 exchange to avoid a substantial depreciation recapture that may occur if the property is held for a long period of time. 

Landtrust Title Is Your Commercial Real Estate Partner

We understand that commercial title requires a different kind of expertise — you need a partner you can trust to handle any of your deals, no matter the size or complexity. That’s where our team of highly experienced title professionals comes in. With Landtrust, you’ve got someone in the trenches with you, focused on solving problems and making sure every deal goes through. 

The bottom line is this: when you work with Landtrust Title, you’re getting a whole team of experts committed to your success. If you have questions about commercial property title services, Landtrust Title Services can help. Please contact us today at [email protected] or by phone at (312) 528-9210.

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