Maximizing your commercial real estate investments requires smart planning and even smarter financial strategies. One such powerful tool at your disposal is the 1031 exchange. By understanding and filing this IRS-sanctioned provision, you can defer capital gains taxes, maximizing the profit you can invest into your new property or properties.
In this blog, we'll explore how engaging in 1031 exchanges can be a pivotal strategy for investors who aim to profit even more from their commercial real estate ventures.
How does a 1031 exchange work?
The standard 1031 exchange is relatively straightforward, and involves only four essential steps.
- Sell your commercial property.
- Instead of paying taxes on the gains from the sale, file a 1031 exchange.
- A qualified intermediary (such as a title company) holds your profit in an escrow account until you find another property to purchase.
- Buy a new, similar property within six months of the previous sale, using the profits that have been sheltered from taxes.
What are some 1031 exchange pitfalls?
In a 1031 exchange, the new property purchased must be “like-kind” to qualify for the swap. But what does “like-kind” mean? The IRS mandates that the replacement property must be of the same nature, character or class as the relinquished property. Additionally, properties outside the United States are never considered "like-kind," so international investments do not qualify for a 1031 exchange.
Another important element of the 1031 exchange is the strict timeline of the transaction. After the sale of your initial property, you have only 45 days to name potential “like-kind” properties that you would like to purchase. The IRS also mandates a total exchange period of 180 days to finalize the transaction, including the original 45-day identification period. If you don’t meet these deadlines, you’ll lose the entire tax deferral benefit, which for most investors is 20% federal tax plus any applicable state taxes.
Lastly, the IRS requires that you engage a “qualified intermediary” (QI) to complete the exchange. The QI, also referred to as an accommodator or facilitator, is a person or entity that assists in facilitating a tax-deferred exchange for you, the property owner. The QI manages the exchange proceeds and serves as the principal in both the sale of the relinquished property and the acquisition of the replacement property. It's important to note that the QI cannot be the taxpayer, a related party or an agent of the taxpayer.
Conclusion
Commercial real estate is a smart investment for many individuals and entities, but smart investors use all the tools in their toolkit. By leveraging a 1031 exchange, investors can easily avoid thousands of dollars in capital gains taxes. If you plan to sell one property and purchase another, similar property in a short amount of time, this strategy may work for you.
Get answers to all your 1031 exchange questions. National 1031 is our official 1031 exchange partner and your expert in guiding you through the process and serving as your Qualified Intermediary. Go to national1031.com to learn more.
