What is a 1031 Exchange in Commercial Real Estate?
When an investor or developer sells a commercial property, they usually have to pay taxes then and there, but not always. An IRS 1031 exchange is a transaction that allows a commercial property seller to defer paying taxes on the sale of the property if they use the funds to buy another, similar property within a specific period of time.
Who Can Use a 1031 Exchange?
Individuals, S corporations, C corporations, trusts, LLCs, and other groups are eligible to request a 1031 exchange for the purpose of deferring their tax burden until later. However, it's important to realize that 1031 exchanges are designed for the exchange of commercial property. As a result, personal homes and vacation residences may not be eligible. In addition, the seller cannot simply use money from the sale of the first commercial property to purchase the second commercial property; the two deals must be part of the same legal transaction (at least in the perspective of the IRS.)
For instance, if an investor sold a small shopping mall (with no debt) for $10 million, they would have $10 million in capital gains, on which they would likely have to pay around 35% in taxes (combining federal and state capital gains, depreciation recapture, and net investment taxes). That would leave them $6.5 million to re-invest into another property. If the investor had to put down 30% (at 70% LTV), they would be able to purchase a property worth $21.66 million. However, if they were able to exchange the property, they could invest the entire $10 million as a down payment, allowing them (assuming the same LTV ratios), they would be able to purchase a property worth up to $33.33 million. As you can see, simply deferring taxes to later allows borrowers to take advantage of significantly more leverage, which can exponentially increase investment returns in the long run.
What Are The Rules of 1031 Exchanges?
While we already mentioned a few of them above, there are quite a few rules that investors must follow in order to make 1031 exchanges successful. They include:
The properties exchanged must be of “like kind”— for instance, an boatyard could not be exchanged for a shopping mall.
The new property must be located within 45 days of the sale of the initial property, and purchased within 180 days of the initial property’s sale.
The 1031 exchange must be performed by a qualified intermediary.
Titles to property cannot be in held by two people at the same time.
A replacement/exchange property needs to be worth equal to or more than the original property.
If the original property had debt on it, the new property must take on at least that amount of debt.
Leftover cash from a 1031 exchange, referred to as “the boot” is taxed as ordinary income.
Any reduction in debt you have with the new property (for instance, if you had $2 million of debt on the original property and only $1.8 million on the new one) will also be taxed as ordinary income.
Can You Get Extra Time to Complete a 1031 Exchange?
Yes, in some cases, you can. One type of IRS 1031 exchange, known as a reverse exchange, allows investors to identify and purchase the similar property before selling the initial property they want to exchange. Investors can do this by hiring an exchange facilitator, often known as an exchange accommodation titleholder (EAT), a legal intermediary who holds the titles of one or more of an investor's properties while they complete the 1031 exchange.
Crowdfunding and 1031 Exchanges
In today’s marketplace, crowdfunding has become an increasingly popular way to raise money for real estate investing. Accordingly, some companies have created vehicles that allow individuals who have sold property in a 1031 exchange to invest the proceeds into crowdfunded properties. By doing this, an investor could invest in a larger property or a group of properties that could, potentially, reduce their expenses and their required legwork, while at the same time raising their potential return.