What is a 1031 Exchange?
In today’s blog post, I thought I’d answer a common question I get from many aspiring commercial real estate investors. This question is, “What is a 1031 exchange?” A 1031 Exchange is a strategy used by investors to defer capital gains & recapture taxes on the sale of commercial investment property. In practice, it’s a swap of “like-kind” investment property for another.
Now, you may be wondering, "What is like-kind property?” The IRS is relatively liberal on their definition of “like-kind” property. As long as the exchange involves "real property" (i.e. land and buildings), it qualifies as like-kind. For example, if you own an apartment complex, you’re not restricted to only exchanging it for another apartment complex. In fact, you could exchange an apartment complex for raw land, or exchange a ranch for a strip mall. The only stipulation is that must be real property. Therefore, you couldn't exchange an apartment complex for a fleet of F-150’s. Now that you understand what can and can't be involved in a 1031 Exchange, let's dive into how to properly execute one.
Securing a Qualified Intermediary
To start, you’ll need to list your property for sale. When marketing your property, make sure your commercial real estate agent is familiar with the 1031 exchange process and that they stipulate you’ll be executing one to potential buyers. Depending on which state you reside in, the buyer may need to sign some additional paperwork prior to purchasing your property.
Once this step is complete, you’ll need to select a “1031 qualified intermediary” for the transaction. A 1031 qualified intermediary (QI) is a company that facilitates Internal Revenue Code section 1031 tax-deferred exchanges. Their role is to facilitate the transaction by drafting the appropriate legal documents, safeguarding the sales proceeds of your original property, consulting with you and your advisors during the 1031 exchange process, and making sure you hit the deadlines to properly execute the exchange.
Once you’ve sold the property in question, the QI will hold the proceeds of the sale in a dedicated escrow account until the exchange property is purchased. During this time period, you’re not allowed to touch ANY of the funds from the sale of your original property. If you do, it’s what’s considered “boot” and you’ll be taxed on the proceeds you withdraw. When looking for a qualified QI, make sure they’re licensed, bonded, insured, and have a track record of delivering excellent results to their clients. For a list of questions to ask a prospective QI, check out the link provided here: https://bit.ly/2wlDt7w
Key Dates to Remember
There are two key dates you need to keep in mind as you execute a 1031 exchange. From the date you sell your original property, you have 45 calendar days to identify the properties you want to perform the exchange on and 180 calendar days to close on one or more of those properties. These dates are non-negotiable and failure to meet these deadlines will result in you having to pay capital gains taxes on the proceeds you receive from the sale of your original property. Because of this tight identification window, it’s highly recommended that you begin your property search prior to closing on your original property. You don’t want to be rushed to pick properties that don’t meet your criteria due to time constraints.
Executing a 1031 Exchange
There are three routes you can take when identifying properties. These are:
1) Three Property Rule – You can identify 3 potential properties to exchange with no restriction on the dollar value of these properties.
2) 95% Rule - If you would like to identify more than three properties, you will be required to close on 95% of the properties you identify with no dollar value restriction.
3) 200% Rule – If you would like to identify more than three properties, the total combined value of the identified properties must be less than 200% of the sales price of your relinquished property.
For example, let’s say that you sell a 10,000 SF shopping center for $1,500,000. If you identify 20 potential exchange properties, you would either close on 19 of them with no dollar value restriction or close on less than 19 but have the sum of the property values be no more than $3,000,000.
Once you’ve compiled your list, you’ll have 180 days from the original close date to purchase your new property/properties. For a great video illustrating the step-by-step process of executing a 1031 exchange, check out the link provided here: https://bit.ly/2MoQIPx.
If you’re interested in executing a 1031 exchange and you’re looking for a brokerage that has experience executing these kinds of transactions, look no further! At the Grisanti Group, our agents have helped many investors effectively execute a 1031 exchange. I’d love to help guide you through this complex process and make your experience as stress-free as possible. If you’d like to learn more about my services and discuss the possibility of working with me, feel free to email me at email@example.com or text/call me at (502) 536-7315.