Section 1031 exchanges can provide significant tax benefits to commercial property owners, especially when dealing with distressed property. Through a 1031 exchange, an investor can defer recognition of gain, by reinvesting in like-kind or similar property within certain time limitations and other restrictions.
A 1031 exchange is an extremely flexible investment tool for almost every type of commercial real estate investment.
1031 Exchange Basics
1. Investment or productive use. The properties exchanged must be held for investment purposes or used in your trade or business. An "investment property" is the passive long-term holding of property, with the expectation of its appreciating in value. Property that does not qualify for a 1031 exchange includes a personal residence, second home or vacation home, inventory property, partnership interests, bonds, notes or stock, stock-in-trade or other securities or evidences of indebtedness or interest.
2. Like-kind exchange. To be "like-kind," the replacement property must be of a similar nature or character to the relinquished property and must be held for productive use in a trade or business or for investment purposes. Examples of like-kind exchanges include a commercial office project for a farm or ranch, a shopping center for an office building, and raw land for a hotel.
3. Exchange does not have to be "simultaneous." An exchange can be simultaneous (i.e., simultaneous swap) or non-simultaneous (i.e. deferred or "Starker Tax Deferred Exchange"). For a non-simultaneous exchange, the taxpayer generally uses a qualified intermediary or exchange facilitator who holds the proceeds of the sale, prepares all legal documents and facilitates the transaction. It is crucial to identify the replacement property at exactly 45 days from the date of the relinquished property's sale. Likewise, the seller/commercial investor must acquire the replacement property within 180 days of the sale of the relinquished property. These time limitations are generally not extendable by the IRS.
4. Title taken in same name. The title on the replacement property should be the same as was on the relinquished property. For example, if an LLC was on the title of the relinquished property, it must be on the title of the replacement property.
5. Cost basis calculation and taxable "boot." As a result of the 1031 exchange, the cost basis in your replacement property will be the same as the property relinquished, less any money you received (i.e., "boot"), which may increase your recognized gain or decrease your recognized loss. The term "boot" refers to other value received in the 1031 Exchange (e.g., money, net debt reduction or other non-like-kind property). You can avoid "boot" by never trading down. This is accomplished by always finding replacement property of equal or greater value to the relinquished property to make sure your 1031 exchange is completely tax-free.
"The main idea behind a 1031 Exchange is that due to the "like-kind" exchange, a commercial investor receives no proceeds in order to pay taxes because it is not considered a taxable event under the Internal Revenue Code. Because you have replaced your old property with new property, you will attain continuity of your investment where gain or loss is deferred and not recognized. This gain or loss is then kept in the replacement property," explains Jack Rose, Chief Strategist at Breakwater Equity Partners.
*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.