How to Use 1031 Exchange When Investing in Commercial Multifamily Properties

When T.J. Starker took on the IRS in the late 1970s 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 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 critical 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 for selling an investment property and buying 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 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. 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.

This rule has some restrictions, so it’s imperative that you talk with a tax professional before conducting a Starker Exchange.

Using a Qualified Intermediary

The transaction must be conducted as an exchange rather than a sale and purchase to comply with IRS regulations. 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 who does it—section 1031 of the IRS tax code mandates that you use a Qualified Intermediary. 

Qualified Intermediaries, also known as accommodators, are either entities or individuals who facilitate the 1031 Exchange and ensure that all of the rules are followed. 

A fundamental 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 obtain a suitable replacement property and transfer it from the seller to you. 

Of course, you must still put the property on the market and execute the purchase and sell agreement directly or through a broker. You must also identify the property or properties you’d like to exchange. And once you sell your property, time is of the essence.

45-Day Identification Window

While the IRS gives real estate investors some flexibility in finding a like-kind property, strict deadlines must be followed to avoid paying capital gains tax. First, you have 45 days to identify the new property/properties you want to acquire. 

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 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, you’ll have to consider their fair market value.

The 200% Rule allows you to identify any 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 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 their aggregate fair market value.

180-Day Exchange Period

Now that you’ve relinquished your property and identified other properties to acquire, you must close on at least one. 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 you have 180 days from your identification window.

A Quick Example

Restrictions aside, the Starker exchange is vital 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 return that money to 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 you can use to control more significant assets and generate more income today.

Multiply this advantage over just a few transactions, and your net worth and current income will significantly jump.

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 real estate is now the only property eligible for tax deferral via an exchange. 

Gone are the days when one could exchange personal property, as well as before the TCJA, when 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 it. 

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 suitable in every situation. There are some scenarios where it might be better not to do a 1031 Exchange. It’s always best to consult your trusted tax advisor before deciding to do a 1031 Exchange. 

When The Taxes Due Will Be Minimal

The benefit of a 1031 exchange is that it defers capital gains tax and avoids depreciation recapture. However, if you haven’t owned the property very long, depreciation recapture will be minimal. 

Also, if the property has gone down in value or experienced minimal appreciation, you’ll have little to no capital gains. 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 allow 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, 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 deferred tax, it probably doesn’t make sense to move forward with an exchange. 

You Can’t Find a Suitable Replacement

1031 Exchanges have time limits. That means you have to find a suitable property within a short time. But what if you can’t?

Is it better to avoid taxes and only buy a property with a negative cash flow or a declining 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 to a successful 1031 exchange, include:

• Analyze whether it makes financial sense to do one, given your unique situation, before putting your property on the market
• Consult with your trusted tax advisor before 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