Commercial Real Estate Blog

This is part five of my six part series to help guide commercial real estate investors through all of the steps of selling their commercial property privately.

The biggest expense to commercial real estate investors when they decide to sell their properties is the capital gains tax.  This is a tax on the profit you made from the sale price of the property minus the purchase price of the property.  This is called the investor's “basis” in the property.  There are other factors that go into determining your basis like any long-term maintenance or additions you made to the property but the end result is a tax of some amount when you sell.  However, while this tax cannot be totally avoided, it can be deferred almost indefinitely using a vehicle from the IRS known as a 1031 Exchange.

What is a 1031 Exchange?

In a standard commercial real estate transaction, the property owner is taxed on any gain realized from the sale. However, using a Section 1031 Exchange, the tax on the gain is deferred until some future date. Section 1031 of the Internal Revenue Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.” A 1031 tax-deferred exchange allows a property owner to trade one or more sold properties for one or more replacement properties of "like-kind".  The capital gains tax on the sale of these properties is deferred until either the seller liquidates his investments or dies.

The legal reasoning behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that gives the seller actual money to pay a tax. So the taxpayer's overall investment is the same, it has just changed form (for example office buildings exchanged for an apartment building). The IRS determined it would not be fair to tax the investor on just a paper gain so instituted the 1031 exchange.

What are the requirements for a 1031 Exchange?

•    Proper Purpose - Both the sold property and the newly purchased property must be held for productive use in a trade or business or for investment. Property bought for immediate resale such as a flip doesn't qualify for this tax exemption.

•    Like Kind – The replacement property acquired in an exchange must be "like-kind" to the property being relinquished. As an example, all qualifying real property located in the United States is like-kind to all other property located in the United States.  Property located outside the United States would not be considered like-kind to property located in the United States. However you can do a 1031 Exchange for property outside the United States to another property that is also outside the United States.

•    Exchange Requirement - The relinquished property must be exchanged for other property, and cannot be liquidated and then the cash used to buy the new property.  This means the 1031 Exchange requires an intermediary to facilitate the transaction.

Who is involved in a 1031 Exchange?

•    Investor/Taxpayer/Exchanger As the person selling your property, you can be referred to by any of these names.

•    Buyer. The person buying your property. This person pays money to the intermediary and then receives the deed.

•    Intermediary. This is any qualified neutral third party not related to the transaction such as a title company or attorney.  The intermediary ensures that all of the regulations are followed and places the funds in an escrow account until the exchange is completed.

•    Seller. The person selling their property to you. This might not be the same person who is purchasing your property in the exchange.  In other words you can sell your property to one party and buy a property from a different party and still qualify for a 1031 Exchange.

What are the specific timing rules for an exchange?

The investor has a maximum of 180 days from the closing of the relinquished property or the due date of that year's tax return, whichever occurs first, to acquire the replacement property. This is called the Acquisition Period. The first 45 days of that period is called the Identification Period. During the 45 days, the investor must identify the property that will be used for replacement. This identification must be in writing, signed by the investor, and received by the intermediary within the time period allotted.  If this does not occur then the 1031 Exchange will be considered null and void and all capital gains owed on the sale will be immediately due.

When the replacement property is sold, how are the capital gains taxes calculated?

The capital gains tax is calculated the same as in any other sale, assuming that you have not converted it to residential use, and that you are not going to do another 1031 Exchange. The tax will be on the difference between the basis of the original property from the basis of the property now being sold minus the depreciation which accrued on the property being sold since it was purchased.

So long as you keep rolling over your investments into new, like-kind properties, you can defer the capital gains taxes owed indefinitely and still reap the benefits from your new properties.

Don’t miss part six of this series where I will talk about the closing process and what you should be aware of as the seller. Please leave your questions or comments!

Disclaimer: Nothing stated in this article should be taken as the giving of legal advice.  As always, you should check with a licensed, competent real estate attorney who specializes in your field when unsure of how to proceed.