Understanding IRC Code Section 1031 and Why You Should Care
Hint: it’s about deferring capital gain taxes
If you think this is one of those dry topics about taxes, think again. It’s important information for anyone selling a commercial real estate property who cares about being protected from capital gains taxes and growing their portfolio.
Internal Revenue Code Section 1031, commonly referred to as a “like-kind exchange,” permits a person to defer capital gains taxes on the sale of property held for investment or productive use in a trade or business. More simply, if a 1031 exchange is structured properly, an investor can sell a property, reinvest the proceeds in a new property, and defer all capital gain taxes.
In a Forward Delayed Exchange, the most common type of exchange, property is sold (Relinquished Property), and the proceeds are used to purchase another property (Replacement Property) within certain timelines. But to qualify for safe harbor tax deferral, the sale proceeds must be held by a Qualified Intermediary between the sale of the Relinquished Property and the purchase of the Replacement Property.
Here’s the math: 1031 permits deferral of federal capital gains taxes (maximum capital gain rate currently 20%), depreciation recapture (25%), net investment income tax (3.8%) and state taxes (generally 8% to 9% where applicable).
And here are four rules related to a 1031 exchange:
1031 Time Frames or Deadlines
45 Days: You have 45 days from the sale of your Relinquished Property to identify your potential Replacement Properties. You can identify any property or properties, subject to the rules of identification that follow.
180 Days: You have 180 days from the sale of your Relinquished Property to close on the purchase of your Replacement Property.
Rules of Identification
- The Three (3) Property Rules – The exchanger may identify up to three properties without regard to their value; or
- The 200% Rule – The exchanger may identify more than three properties, provided their combined fair market value does not exceed 200% of value of the property sold; or
- The 95% Rule – The exchanger may identify any number of properties, without regard to their value, provided the exchanger acquires 95% of the fair market value of those properties.
Full Tax Deferral
For full tax deferral, an exchanger must reinvest all of the proceeds in a “like-kind” replacement property and have the same or greater amount of debt on the replacement property or properties. Another way of looking at this is that you need to purchase replacement property of equal or greater value, and reinvest all of the net equity.
Property sold in a 1031 exchange (Relinquished Property) must be “like-kind” to the property purchased (Replacement Property). Or, in a 1031 exchange involving real property, all real property is “like-kind” for other real property. (Real property is not like-kind to personal property.) But raw land can be “like-kind” for a shopping center, and an office building can be “like-kind” for a residential apartment complex, for example.
Here’s an example from the Federation of Exchange Accommodations of the “powerful protection” a 1031 exchange can offer:
- An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $130,000 remains to reinvest in another property.
- Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
- If the same investor chose to exchange, however, he or she would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.