Pros and Cons of a 1031 Tax-Deferred Exchange of Commercial Property

A 1031 Exchange, also known as a tax-deferred exchange, is a common, fairly straightforward strategy that affords significant tax advantages to commercial property owners.
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A 1031 Exchange, also known as a tax-deferred exchange, is a common, fairly straightforward strategy that affords significant tax advantages to commercial property owners. Thanks to IRC § 1031, real estate investors may sell or relinquish certain qualified property, reinvest proceeds from that property and acquire a replacement property, pursuant to certain time limitations and other regulations. To put it simply, at time of sale (which includes forced sales such as foreclosures, short sales and deeds in lieu of foreclosure), dispositions of real property are taxable in the year in which you sell the property, but employing a 1031 Exchange defers that taxable event.

Pros of a 1031 Exchange

1. Deferral of taxes. A 1031 Exchange allows you to sell your investment property and reinvest in a replacement property in order to defer ordinary income, depreciation recapture and/or capital gain taxes. These types of taxes can be quite significant, especially with a low adjusted cost basis, which is why the IRS affords you this invaluable exception in exchanging business or investment property.

2. Leverage and increased cash flow for reinvestment. By deferring taxes, you will have more money currently available for investment. This increased purchasing power gives you the extra leverage to acquire, for example, a property or several properties with significantly higher investment benefits than if you sold the original property, paid all the taxes associated with the sale and purchased a new property.

3. Relief from management. If you own a property or several properties burdened with extensive maintenance costs and requiring intensive management, you may exchange and replace property for others with less responsibility (e.g., having an on-site manager).

4. Wealth and asset accumulation. "1031 exchanges are a great wealth building tool," said Jack Rose, Chief Strategist at Breakwater Equity Partners. "Commercial property investors who continually perform 1031 exchanges through their lives will benefit from significant cash flow and net worth increases, much more so than a real estate investor that chooses to sell and pay taxes each time a sale occurs." In theory, one could exchange into numerous investment properties over the years and pass those investments on to their children at the time of their passing. At that time, their children could realize a step-up in the cost basis of all of those investments to current fair market value, essentially eliminating the tax burden altogether.

Cons of a 1031 Exchange
1. Multiple procedures, rules and regulations to follow. The IRS has established regulations in a 1031 Exchange in accordance with the competing interests of collecting taxes and rewarding taxpayers for investing back into the economy. If these regulations are fully complied with, no income will be recognized at time of the commercial property exchange transaction. Not strictly adhering to these regulations, however, could doom your tax status and in fact you could incur certain penalties.

2. Difficulty in meeting IRS rules and regulations. Not surprisingly, investors frequently hit roadblocks when trying to comply with 1031 Exchange regulations. A common problem is finding a replacement property within the first 45 days after the sale of your relinquished property. To make matters worse, the IRS generally does not allow extensions of this time. That is why it is so important to meet with a real estate advisory, many of which specialize in identifying and structuring 1031 exchange opportunities, to assure your 1031 is a success.

3. Reduced basis on property acquired. Due to the exchange, the replacement property's tax basis is reduced. Tax basis of the replacement property is essentially the purchase price less the gain deferred on the sale of the relinquished property as a result of the 1031 Exchange transaction. Thus, if a real estate investor ever sells their replacement property, the deferred gain will be taxed.

4. Losses cannot be recognized. Just as applicable taxes are deferred, losses are also deferred. In a windfall profit year, for instance, deferring losses that could have offset large profits could be a painful decision. One must carefully weigh the benefits of such a deferral.

5. Future increases in tax rates. If you go to sell your investment property in the future, you may recognize higher capital gains rates and other tax hikes as we have seen this year. The current Administration saw fit to raise the capital gains tax, depending on your income level, from 15% to 20% as well as add an "Obama-Care" Medicare tax of 3.8% on certain gains.

6. Only tax deferred, not tax-free. Remember, this is a tax-deferred transaction, not tax-free. Should you decide to sell, your tax liability will be fully recognized.

Executing a 1031 Exchange should be completed under the guidance of a seasoned professional such as a reputable commercial real estate investment firm. You can get tripped up on the many complex rules and regulations that the IRS sets forth. Finding a knowledgeable professional is critical in assisting you in assessing your tax liabilities of a sale versus an exchange, whether an exchange suits your investment goals and overall plan and finding a suitable replacement property.

*Warning: This information is not intended to constitute legal, financial, or tax advice and should not be used in lieu of any professional's advice.

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