Section 1031 of the Internal Revenue Code allows commercial real estate investors to defer tax liability from the sale of a real estate investment by using those profits to purchase another ‘like-kind’ property.
This practice is often referred to as a 1031 Tax Exchange, or a ‘like kind exchange’, and was originally required to be a simultaneous transfer of ownership. However, when T.J. Starker took on the IRS during the late 1970s, his case re-defined how investors could manage their portfolios and permanently changed the core strategies of commercial real estate investing.
In 1979 Starker v. United States resulted in the expansion of section 1031 to allow a non-simultaneous exchange of real estate as long as it happens within the 1031 exchange timeline. In reference to his triumph, these non-simultaneous exchanges are sometimes referred to as a Starker exchange.
Develop Permanent Wealth Through Tax Deferred Exchanges
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 invest in commercial real estate to protect and grow their wealth.
There is an excellent infographic on the process created by a 1031 Exchange intermediary company (i.e., they don’t offer investments, they just help you ensure the exchange stays compliant).
These exchanges are a very powerful wealth amplification tool.
Your returns can be magnified by 15% to 20% (typical long-term capital gains rate) or more depending on your situation. If you have a $500,000 gain on a property you’ve held for 10 years that’s $100,000 of tax (at a minimum) deferred and fully reinvestable in the next asset, providing even more current income and equity growth into the future.
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, our overview of the most important 1031 Exchange rules will illustrate exactly why they’re considered one of the biggest tax benefits of real estate investing.
The Investment Must be of Like Kind
An investor must use the proceeds from a sale to invest in another property of like-kind. This does not restrict selling a shopping center and purchasing an apartment building, but it would prevent selling a shopping center and buying a vacation home.
Properties that qualify as ‘like-kind’ can be very broad, as the only restrictions are that they cannot be personal property, such as a residential home. They also must be located within the United States. A good rule of thumb is that most U.S. income-producing commercial real estate investments are considered like kind and are eligible 1031 exchange properties.
That being said, it is imperative that you consult with a tax professional when conducting a like kind exchange. Certain conditions could result in which you’d be taxed on the full amount of the sale and trigger depreciation recapture.
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.
While this distinction might not seem important, the use of a Qualified Intermediary is required to ensure the transaction meets IRS approval. Also known as an Accommodator, Qualified Intermediaries are typically companies that serve as official facilitators for 1031 exchanges.
If you are considering a 1031 exchange, selecting a Qualified Intermediary should occur well in advance of the sale.
1031 Exchange Timeline
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 must identify the new property within 45 days of the sale of the original property. Second, you must close on that purchase within 180 days of the sale of the original property.
There are a few extensions for these deadlines, which we will cover in more detail later.
A Quick Example
Restrictions aside, the like kind 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 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 37% ($37,000).
On the other hand, if you sold a commercial property that also netted a profit of $100,000, you could employ a Starker Exchange and put that profit in a like kind investment. You would defer anywhere from $15,000-$38,000 in taxes.
That extra $15,000 to $38,000 of investable proceeds can be used 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.
How to 1031 Exchange into Commercial Multifamily Properties
I’ve been in discussions with a lot of people regarding 1031 Exchange options and how they can transfer out of their non-performing or headache-inducing residential properties into one or more of our stable multifamily investments.
People want to know how 1031 Exchanges work and how we can help them.
The following outlines key considerations for using a 1031 Exchange as a means to invest with 37th Parallel Properties.
How to Determine if You Qualify for a 1031 Exchange
There are several conditions you need to consider when evaluating a like kind exchange, but these first three can be a useful guide.
1. Do you have like-kind property that you have not sold yet?
To exchange into commercial multifamily investments (income producing real estate) you will need another income producing property to sell. This could be a 1-4 unit rental property, rental condo, strip retail center, small medical office building, etc. Generally, it just needs to be an income producing real estate asset.
2. If you have sold like-kind property, did you set up a 1031 Exchange and are you still within your 45-day next investment identification window?
This is the most time compressed scenario, but it still may be worth evaluating if you would like additional exchange options.
3. Is the capital gain you want to defer worth it?
Now, I am a major proponent of minimizing your taxes as much as possible, but sometimes it just doesn’t make sense. In our experience, any capital gain of less than $50,000 is – in all likelihood – too small to worry about a) setting up the exchange and b) dealing with the downstream restrictions and considerations on your 1031 investment.
Get Help Navigating the Process
As our investor family has grown and we’ve moved into larger acquisitions, we’ve had more and more opportunities for investors to use like kind exchanges to transition into stable-growth income producing apartment assets.
If you have lazy real estate assets that aren’t generating the economic results you want or you’re tired of being a landlord, I would highly encourage you to chat with us to see if we can help you.
If you are an accredited investor then I would strongly encourage you to schedule an introductory call to get direct access to the best risk-adjusted return asset class available – commercial multifamily apartments.