Lets talk about a 1031 exchange, its a tool that commercial real estate investors have at their fingertips when they are disposing of properties and acquiring another with the proceeds.
Now with that said I think that we need to understand the dynamics of a 1031 exchange at bit first because a properly structured and executed 1031 exchange allows for a commercial real estate investor to dispose of a property without being subjected to the good ole capital gains tax and then they can subsequently use those full funds to purchase a new “Like-Kind” property.
Now before we move further let me expand on the term “Like-Kind” as its pretty general and doesn’t mean what you may think it does. Most that are not familiar with a 1031 would automatically think that if they dispose of an office building that they would have to buy an identical office building of equal value and that is not the case. You can exchange an office building for an apartment building, shopping center or even raw land for development. So as you can see the Internal Revenue Code rule is pretty flexible.
Now here is what is stated in the Internal Revenue Code Section 1031 (a)(1) :
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Now let me expand a little further into that with an example,
A commercial real estate investor has a $500,000 capital gain and incurs a tax liability of approximately $175,000 in combined taxes (which include federal and state capital gains taxes and depreciation recapture if any) when the property is disposed of. Only $325,000 is what is left over to reinvest in another property without the use of new money.
Now lets assume that the investor needs a 25% down payment with a 75% loan-to-value ratio, the investor would only be able to purchase a property valued at approximately $1,300,000 , that if they do not intend on adding new money to the investment.
Now here is where it gets pretty interesting, so if the same investor made the decision to do a 1031 exchange then the investor would be able to reinvest the entire amount of $500,000 and then purchase a property worth in the range of $2,000,000 , again assuming they do not invest new money into the deal, and also with this we are still using the 25/75% ratio. (of course the dollar amounts can vary from $100,000 and up, I just used those numbers as an example)
As I mentioned earlier this is a prime example of the benefits and actual protection that a 1031 exchange affords to a commercial real estate investor. The main protection is that from the capital gains tax and this protection allows the investor to realize an increased return on their investment and their portfolio growth.
I just have to stress that any investor looking to take advantage of a 1031 exchange should consult and/or retain an experience commercial real estate attorney. It may cost you a little more now but trust me it will be an asset to you later on should an issue arise.
One other thing to understand about a 1031 exchange is that you may even be able to exchange one business for another, that is a different animal all together however it is possible but retain that commercial real estate attorney if you are exploring this option. Also 1031 exchanges are not for personal use they are only for investment and business properties.
I’ll be writing more commercial real estate articles and will touch more on 1031 exchanges.