One of the primary reasons people choose to invest in real estate is because it’s a highly tax-advantageous industry. There are a number of reasons why this is the case, but one tool in particular, helps investors buy commercial real estate: the 1031 exchange.
In theory, the concept itself is simple: Reinvest the proceeds from the sale of business or investment property into a like-kind investment in order to defer paying capital gains tax. Doing so increases an investors’ purchasing power because he can use 100% of his current property equity to invest in a replacement property, such as a higher value industrial or commercial asset. Using a 1031 exchange is a great tool for investors looking to grow their real estate portfolios.
In reality, 1031 exchanges are a bit more complex. Section 1031 of the Internal Revenue Code (from which the term gets its name) contains many nuances that can be daunting to a novice investor.
Types of 1031 Exchanges
Most real estate investors are familiar with a “delayed exchange,” the most common form of 1031 exchange. Yet there are actually five different forms of 1031 exchanges, and each can be used for different purposes.
Simultaneous Exchange
The Simultaneous Exchange was the original 1031 exchange, and allows investors to swap properties directly, relinquishing and closing on their replacement property within the same day – hence the name “Simultaneous Exchange”. With this type of exchange, two parties literally exchange the deeds and other necessary documents to trade assets, simultaneously transferring ownership to one another. No monetary compensation is allowed.
Delayed Exchange
The Delayed Exchange is the most common type of 1031 exchange. A Delayed Exchange is one in which a third party, known as a “Qualified Intermediary” (QI), facilitates the selling of one’s property and assures that proceeds are used for the acquisition of another like-kind property. Upon the QI’s receipt of money from the sale of a property, an investor has 45 days to formally identify which replacement property (or properties) he wants to buy.
The “exchange period” is an important deadline investors must monitor while doing a 1031 exchange. An investor only has 180 days from the date he closes on the relinquished property to close on the replacement property, otherwise known as the exchange period. The transaction mustbe settled within 180 days for the Delayed Exchange to be considered successful.
Improvement Exchange
An Improvement Exchange allows an investor to make improvements on a new replacement property using his tax-deferred equity prior to closing on the replacement property. This type of exchange is also referred to as a “construction” or “built-to-suit” exchange. It is particularly useful for investors who are interested in acquiring a property that is not of equal or greater value than the property they intend to relinquish; for investors willing to take on the ground-up construction of their new replacement property; or for investors who have identified a property of equal or greater value that is in need of significant improvements.
Personal Property Exchange
The Personal Property Exchange involves the sale of a personal asset to invest in another like-kind asset. It may be a tangible asset (e.g. vehicles, artwork, office furniture) or intangible (e.g. business licenses, copyrights, website URL). Personal Property Exchanges are often used in conjunction with other forms of 1031 exchanges in order to sell personal and real property at the same time.
Reverse Exchange
All of the aforementioned types of 1031 exchanges are considered “forward” exchanges. The outlier is the Reverse 1031 Exchange, which is used when an investor acquires a replacement property before conveying the relinquished property to the new buyer. These are the most complicated forms of 1031 exchanges, and most would argue the riskiest. This is because an investor is still obligated to find and close on a replacement property within the 45- and 180-day timelines.
Case Study
Investor Sam owns a cooler - freezer warehouse in Miami that has appreciated almost three-fold since he purchased it 20 years ago. Given this increase in value and Sam’s need for a larger warehouse for his business, he decides to sell the property. Before he contacts a real estate broker to market the freezer warehouse, Sam calls his long-time CPA to evaluate the tax considerations of selling the property.
Over the 20 years that Sam has owned the building, his net adjusted basis has decreased significantly due to the depreciation he has recognized.
Original Purchase Price: $1,500,000
Capital Improvements: $50,000
Depreciation Taken: ($1,000,000)
Net Adjusted Basis: $550,000
Sam’s CPA tells him that his capital gain and resulting tax liability will be high because of the property’s strong appreciation and low net adjusted basis. A potential sale might look like the following:
Sales Price Today: $4,250,000
Net Adjusted Basis: ($550,000)
Closing Costs: ($200,000)
Capital Gain: $3,500,000
Sam will be able to claim $1 million in depreciation recapture (generally taxes at 25%). Since Sam is in the highest tax bracket, the remaining $2.5 million in capital gain will be taxed at a long-term federal capital gain rate of 20%. Sam’s potential tax liability looks something like this:
Capital Gain: $3,500,000
Depreciation Recapture: ($1,000,000)
Net Capital Gain: $2,500,000
Tax on Depreciation Recapture (25%): ($250,000)
Federal Capital Gains Tax (20%): ($500,000)
Medicare Surtax (3.8%): ($95,000)
Total Tax Liability: $845,000
But Sam doesn’t own the Miami freezer warehouse outright. He still has an outstanding loan balance in the amount of $600,000. So if he were to sell for $4,250,000 he’s only walking away with $3,450,000 from the sale once he pays off his loan and pays for his closing costs. After he pays taxes on those proceeds ($3,450,000 - $845,000) he’s really only left with $2,605,000 in terms of sales proceeds.
Sam’s CPA also reminds him that if he were to pay the capital gains taxes and reinvest his after-tax proceeds into a new acquisition (assuming a 70% loan-to-value ratio), his purchasing power weakens. Sam decides it’s time to sell his freezer warehouse in Miami via a 1031 exchange.
Conclusion
There are obviously a number of benefits to utilizing a 1031 exchange: Seller can defer paying capital gains tax, increase purchasing power when investing in another like-kind investment, and accumulate a larger portfolio of real estate that can be passed down to heirs. Savvy real estate investors use 1031 exchanges all the time.
For more information on 1031 Exchange and Industrial Real Estate in Miami, contact us directly at 786-433-2380. Our team of experts can help you “trade up” your current warehouse in Miami into a more efficient building.
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