The Power of the 1031 Exchange
Commercial and Investment real estate transactions have been moving at a brisk pace and a considerable percentage of those sales have been structured as 1031 Exchanges, allowing sellers to defer taxes otherwise due in the year of sale. Often the taxes deferred are used to repurpose or improve the replacement properties. This helps to create jobs and stimulate the post pandemic economy.
Depending on your circumstances and goals, it may be a good time to re-assess, then reposition your portfolio utilizing a 1031 Tax Deferred Exchange. A 1031 Exchange permits an investor to defer the federal and state capital gains tax, gain due to depreciation, net investment tax and even some state-imposed non-resident withholding taxes. That can be upwards of 25-30% of your gain, equating to thousands of dollars instantly saved and used to reinvest in new investment property through the Tax Deferred Exchange.
We asked our own Patricia Flowers, an industry veteran with over 20 years of experience who consults with hundreds of taxpayers each year ranging from owners of vacation cottages to CFOs of Fortune 500 companies, to explain this year’s surge of interest in 1031 Exchanges. Here are her top 5 reasons to exchange:
There is a very good chance your property has appreciated in value, making it a great time to sell. A 1031 Exchange affords you the opportunity to preserve your equity, keep the proceeds you would have set aside to pay taxes and instead deploy the funds to the purchase of new real estate with greater potential. Keep your equity working for you.
Your apartment building, shopping center, commercial, industrial building, investment condo, single family rental or other investment property may not be yielding the returns you expected. Rather than taking the time and personal funds to physically improve the property hoping for a small increase in rents, consider selling it now and exchanging into new property which may be in a better location, allow more depreciation, generate higher rents, etc. This may immediately increase your cash flow.
Each year taxpayers are eligible to take depreciation deductions on their commercial/investment property until it is fully depreciated. It is a benefit to you at the time, but 25% of that depreciation is recaptured by the federal government when the property is sold. This tax can be deferred by utilizing a 1031 Exchange to purchase new property.
Many think that the IRS “like-kind” requirement forces taxpayers to exchange into the same type of property as they sold. Not true. A taxpayer can mix and match property types, as long as the property is held for productive use in a trade, business or for investment. Therefore, a taxpayer can sell a multi-family and purchase a vacation rental, or sell an apartment building and purchase commercial. Land and buildings, perpetual easements, leaseholds, tenant-in-common (TIC) and Delaware Statutory Trust (DST) interests are all qualified properties for an Exchange.
In fact, you can sell one property and deploy the cash proceeds towards down payments on two or three replacements through a single exchange to grow your real estate portfolio, thereby hedging the investment risk inherent in a single property. Alternatively, you can consolidate funds from the sale of multiple properties and exchange for one larger investment purchase. A 1031 Exchange gives you opportunity to maximize your investments.
Rather than sell a property outright, pay the 25-30% in taxes and have only the remaining funds for deposit into your low rate savings account to pass on to your heirs, you could exchange. If you are holding investment property that had been part of a 1031 Exchange, upon your death your heirs get the stepped-up basis. All the built-in gain disappears upon your death. What that means is that the value of the property at the date of death would pass through the estate to your heirs. If they decide to sell for that same appraised value, there would be no capital gain for them to owe tax on and the profits are theirs to do with what they wish, which a great benefit to pass on.
Why a Qualified Intermediary?
The IRS regulations state the taxpayer cannot have actual or constructive receipt of funds in between the sale and the purchase, and still claim tax deferred treatment. The Qualified Intermediary (QI) is the neutral third party to structure the 1031 Exchange on behalf of the taxpayer. As the largest Qualified Intermediary in the country, investment owners and advisors depend on IPX1031 to help them realize the benefits of participating in an IRC Section 1031 Tax Deferred Exchange. Although the QI’s main focus is to actually facilitate the exchange and control funds between the sale and purchase, at IPX1031 much of our role takes place prior to the exchange itself. We work in conjunction with clients, brokers, tax and legal advisors to guide them through the specifics of the Code, then apply a strategy to the taxpayer’s specific scenario.
With the current market moving as it is, an understanding of Section 1031 is essential to creating opportunities for investors looking for options to reposition assets, generate more cash flow and protect estates. Don’t “just pay the tax” because you think it’s the lowest it will ever be. Keep your equity and let it work for you.