The IRS Code 1031 Tax Deferred Exchange (“exchange”) is often talked about in commercial real estate circles as an option for those property owners looking to sell an asset while also protecting themselves from exposure to federal and state capital gains taxes. Let's Face it, nobody likes to write checks to the government. This is generally and especially true for most hardworking business people who don’t always view the government as the best steward of the money entrusted to their care.
Well, it is important to recognize that we cannot avoid taxes altogether - they must be paid, eventually. However, with the guidance of your tax professional, the use of an exchange accommodator, and the proper help of a professional real estate advisor, the payment of these taxes can be deferred and the use of those funds can instead be leveraged for continued growth of the real estate portfolio. We will explain this strategy in brief below, but for further review and information, please contact me and my team as we can help put you in touch with the right people.
So what should we know about these 1031 Exchanges? Let’s see…
1. Dollars & Sense
2. Property Determinants
3. Timing Factors
The first consideration is related to dollars and sence. Is it worth it to explore an exchange or does it just make sense to do a traditional sale and pay your taxes? This depends on what the projected ‘capital gains’ are from the sale. The term capital gains refers to the acquired wealth you received from the sale; it is calculated by deducting the original purchase price from the current market value sales price. For example, if you bought a building for $1,000,000 and sold it for $2,000,000 your capital gains would be $1,000,000. Presently, in California, estimated capital gains tax rates are presently in the range of 30%+/- when you factor in state and federal rates. That is around $300,000+/- for every $1,000,000 in capital gains. If you can reinvest that money at a 6% annual return, that amounts to $18,000 per year that you would earn from the deferred taxes (you would retain your $300,000 while receiving an $18,000 per year return on that money).
The next item to consider is the property itself. What kind of property are you selling? The property you are selling can be referred to as the “down-leg” property and the property(ies) you are buying can be referred to as the “up-leg” property. The key factor in facilitating a 1031 exchange is that you must purchase a “like kind” up-leg property. Fortunately, the “like kind” definition is broad enough to include any income-producing property for any other income-producing property. For example, you can sell an industrial building and buy an apartment, retail center, office building, land, or residential units so long as you hold the property for income producing purposes.
The most important factor is identifying an “up-leg” property that is a quality asset.
The third consideration is the timing of the process. The IRS code calls for strict guidelines regarding the facilitation of this exchange. These deadlines are all calculated from the closing date of the original down-leg sale. For example, from the day you close escrow on the sale of your down-leg property, you have 45 days to identify the up-leg property you are going to purchase. Additionally, from the day you close on the sale of your down-leg property, you have a total of 180 days to close on the exchange up-leg property(ies).
Overview of Information about Facilitating a Proper 1031 Tax Deferred Exchange
This property exchange process may be a good option for you, depending on your situation. Contact me to discuss your specific scenario and we can develop a plan to help continue to grow your wealth.
Christopher J. Destino, SIOR, a Principal at Lee & Associates, is an engaging, responsive professional who enjoys working closely with his clients and helping them succeed.