When T.J. Starker took on the IRS in the late 1970’s and won, he re-defined how investors could manage their portfolios and permanently changed the core strategies of commercial real estate investors.
The resulting tax code modifications, commonly referred to as the 1031 Starker Exchange, allow commercial real estate investors to defer capital gains tax from the sale of a real estate investment if they apply those profits to the purchase of another real estate investment within a specific time period.
This tax-deferred exchange is not available to those who trade in stocks and bonds and is one of several reasons why 90% of the Forbes 400 use commercial real estate to protect and grow their wealth.
As is the case with most tax laws, there are some non-negotiable steps an investor must follow. This article is by no means a substitute for professional tax advice. However, this overview of the key requirements will illustrate the unique real estate investing benefits of the 1031 Starker Exchange.
What is a 1031 Exchange?
A 1031 Exchange is a procedure that one can follow to sell an investment property and buy another while deferring capital gains tax. Typically when one sells an investment for profit, they have to pay capital gains tax.
Real estate is no different. However, section 1031 of the tax code allows for an exception that when followed permits that capital gains tax to be deferred. It’s a great benefit that sounds easy, but of course there are rules.
1031 Exchange Rules and Qualifications
The Investment Must be of Like Kind
An investor must use the proceeds from a sale to invest in another investment of the same kind.
While this may sound restrictive, it’s not. In fact, it’s the opposite as the new property doesn’t have to be the same type, grade, or condition.
A good rule of thumb is that most U.S. income-producing commercial real estate investments are considered like kind and therefore eligible for a 1031 Exchange.
So a shopping center can be exchanged for an apartment building and an office building can be exchanged for a hotel. The key is that it has to be one income producing property in exchange for another to be considered like kind.
There are some restrictions to this rule, so it’s imperative you talk with a tax professional before conducting a Starker Exchange.
Using a Qualified Intermediary
In order to comply with IRS regulations, the transaction must be conducted as an exchange rather than a sale and purchase. Think of it as swapping one property for another.
And since the property is yours, you’ll be driving this exchange. However, you won’t be the one that actually does it. That’s because section 1031 of the IRS tax code mandates that you use a Qualified Intermediary.
Qualified Intermediaries are also known as accommodators. They are either an entity or a person that facilitates the 1031 Exchange and makes sure that all of the rules are followed.
A key principle in an exchange is that the money can’t touch your hands or bank account. Instead, the accommodator acquires and transfers your property to the new buyer. They hold the proceeds from that property to acquire a suitable replacement property and transfer it from the seller to you.
Of course you still have to put the property on the market and execute the purchase and sell agreement either directly or through a broker. You also have to identify the property or properties you wish to exchange into. And once you sell your property, time is of the essence.
45-Day Identification Window
While the IRS gives the real estate investor some flexibility in finding a like kind property, there are strict deadlines that must be followed in order to avoid paying capital gains tax. First, you have 45 days to identify the new property/properties you want to acquire.
Easily the most commonly used rule in the 45-day identification window is the 3-Property rule. This rule allows you to identify up to three properties that you’d be willing to acquire in exchange for the property you sold.
The 3-Property rule allows you to do that without regard to the fair market value of these properties. If you’d like to identify more than three properties, then you’ll have to consider their fair market value.
The 200% Rule allows you to identify any number of properties you wish as long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of the relinquished property.
The third rule is pretty obscure and rarely used. It’s the 95% Rule and it only applies if you identify more than three properties and the aggregate value exceeds 200% of the relinquished property.
It states that you can identify as many properties as you like as long as you acquire at least 95% of the aggregate fair market value of those properties.
180-Day Exchange Period
Now that you’ve relinquished your property and identified other properties to acquire, you have to close on at least one of those properties. And you have 180 days to do that.
It’s important to remember that the 180-day window is from the day that your original property was sold. Don’t get confused and think that you have 180 days from your identification window.
A Quick Example
Restrictions aside, the Starker exchange is considered a vital tool for any commercial real estate investor. A quick comparison between selling stock and selling a commercial real estate property shows you why:
Let’s say you sell several hundred shares of a stock and declare a profit of $100,000. Even if you wish to put that money right back into another investment, you are still required to pay capital gains tax. If the stock was held for over a year, the tax is either 15% ($15,000) or 20% ($20,000) depending on your income. If the stock was held for less than a year, you are taxed at your current income tax rate which could be as high as 38% ($38,000).
On the other hand, if you sold a commercial multifamily building that also netted a profit of $100,000, you could employ a Starker Exchange and put that profit in a like kind investment within the required timeframe. You would defer $15,000-$38,000 in taxes.
That’s $15,000 to $38,000 of investable proceeds that you can use to control larger assets and generate more income today.
Multiply this advantage over just a few transactions and you will have made a significant jump in your net worth and your current income.
The TCJA Limits The Scope of 1031 Starker Exchanges
The Tax Cuts and Jobs Act (TCJA) became the law of the land on January 1, 2018. It limited property that was eligible for 1031 exchange to only real property. That means that real estate is now the only property eligible for tax deferral via an exchange.
Gone are the days in which one could exchange personal property as well. Before the TCJA people could exchange things like livestock, aircraft, boats, heavy machinery, artwork, and collectibles. Today, 1031 Exchanges apply exclusively to real estate assets and nothing else.
Do You Own Real Property Held For Productive Use Or Investment?
The tax deferral benefit of a 1031 Starker Exchange has a multiplying effect on wealth. And there are many good reasons to utilize them.
Be sure to seek professional advice before starting and always use a reputable qualified intermediary as required by the tax code. As long as you follow the rules and pay attention to the timeline, you’ll be well on your way to executing your exchange.
When to Not Use a 1031 Exchange
Deferring taxes allows you to build wealth faster and accumulate more. So it’s not surprising why so many investors love employing 1031 exchanges. However, an exchange may not be right in every situation. There are some scenarios in which it might be better not to do a 1031 Exchange. It’s always best to consult your trusted tax advisor first, before deciding to do a 1031 Exchange or not.
When The Taxes Due Will Be Minimal
The benefit of a 1031 exchange is to defer capital gains tax and avoid depreciation recapture. However, if you haven’t owned the property very long, then depreciation recapture will be minimal.
Also if the property has gone down in value or experienced minimal appreciation then you’ll have little to no capital gains anyway. In these scenarios, it may not make sense to employ a 1031 Exchange.
If You Own The Property In A Self-Directed IRA
Qualified retirement accounts like a self-directed IRA allows one to invest in real estate. If you do so, that account is already tax deferred. Thus there shouldn’t be a reason to engage in a 1031 Exchange when selling a property.
When The Transaction Costs of a 1031 Exchange Exceed The Tax Owed
As mentioned earlier, a 1031 Exchange must be executed using a qualified intermediary. That work isn’t free of charge. You need to understand the fee structures associated with a 1031 Exchange. If those fees exceed the tax being deferred then it probably doesn’t make sense to move forward with an exchange.
You Can’t Find a Suitable Replacement
Is it worth avoiding the tax hit just to own a dog of a property? 1031 Exchanges have time limits. That means that you have to find a suitable property within a short period of time. But what if you can’t?
Is it better to avoid taxes, only to buy a property that is cash flow negative or declining in value? Perhaps or perhaps not. Ultimately, you invest in real estate to make money. Legally avoiding taxes is a secondary benefit. Don’t lose sight of those priorities. If you can’t find the right property, it might be better to pay the tax.
1031 Exchanges are a unique benefit only available to real estate investors. By deferring capital gains taxes, one can build wealth faster than would otherwise be possible.
To summarize the keys of a successful 1031 exchange, include:
- Analyze whether it makes financial sense to do one given your unique situation prior to putting your property on the market
- Consult with your trusted tax advisor prior to putting your property on the market
- Begin looking for possible replacement properties as early as possible
- Utilize a qualified intermediary
- Keep track of your 45 day naming window and your 180 day closing window
- Have a backup plan should your primary plan fall through
If you’d like to reach out now and discuss your individual situation, we’d welcome that call. Simply schedule some time to speak with one of our advisors.