Arizona Commercial Real Estate (“ACRE”) can help you facilitate your tax deferred exchange of commercial real estate, saving you time and of course more importantly, money.
I am pleased that ACRE just added exchanges to our rapidly growing menu of commercial real estate services. Please Contact me to learn about what ACRE is doing with tax deferred exchanges.
But what is a tax deferred exchange and how can an investor benefit by using the exchange?
First of all, not everyone who owns commercial real estate will want to take advantage of a 1031 tax exchange simply because it doesn’t fit their economic objectives.
Now let me share with you what a 1031 exchange is and how you can benefit from it.
A 1031 tax-deferred exchange, named after Section 1031 of the Internal Revenue Code, is an investment strategy that allows real estate investors to delay paying capital gains taxes when they sell an investment property and reinvest the proceeds into a new “like-kind” property.
The central concept behind an exchange is tax deferral not tax elimination. It is important to understand that a 1031 exchange does not eliminate tax obligations, it defers the obligation to pay the tax on gains until a future point in time.
In fact, the way I look at is that a tax deferred exchange allows an investor to invest the tax obligation in a new acquisition. Pretty cool! Best of all, ACRE knows precisely how to help our clients execute exchanges.
By rolling the profit and any tax gain from one property into another, you continue your investment without immediately losing a large portion of your equity to the IRS. Taxes generally only become due if you eventually sell a property for cash without doing another exchange.
There are strict some requirements to qualify for an exchange. To qualify for a deferred tax benefit, an investor must follow several rigid federal rules, among which are the following five core rules.
Rule 1: The Like-Kind Requirement
Both the property you sell (the “relinquished” property) and the one you buy (the “replacement” property) must be held for business or investment use. Interestingly, “like-kind” is broadly defined; for example, you can exchange a rental house for an office building or vacant land.
Rule 2: Use of a Qualified Intermediary
A investor is not qualified to touch the money from the sale of the relinquished property, the one the investor is planning to exchange for another. Therefore, a neutral third-party, known as a “Qualified Intermediary” must be employed to hold an account for the funds in escrow and facilitate the capital transfer to the new property being acquired, i.e., the replacement Property.
Rule 3: Equal or Greater Value Property
To fully defer all taxes, the new (replacement) property must be of equal or greater value than the one sold, and all net proceeds, after closing costs, must be reinvested in the new property. If an investor receives cash or has a smaller mortgage on the new property, that difference (called “boot”) will be taxable.
Rule 4: Same Taxpayer Rule
The individual or entity (LLC, Sub S Corp, Inc, etc) on the title of the old property must generally be the same as the one on the new property.
Rule 5: Critical Timing-Critical Dates
The IRS enforces two concurrent, non-extendable timelines that start the day you close on your original property:
1. 45-Day Identification Period: You have exactly 45 calendar days to identify potential replacement properties in writing to your QI.
2. 180-Day Exchange Period: You must complete the purchase of your new property within 180 calendar days (or by your tax return due date, whichever is earlier).
Why and how do Investors use the power of the tax deferred exchange? First and foremost, investors use the exchange opportunity to grow their property portfolio. Reinvesting the money that would have gone to taxes allows you to buy more expensive or higher-income producing and higher appreciating, higher demand properties.
Secondly, the exchange can help create investment diversity. You can trade a single-family home for a multi-unit complex or move your investments to a new market in another location or another state.
Finally, exchanging is a key investment strategy used to create generational wealth. If you hold the property until death, your heirs may receive a “stepped-up basis” to its current market value, which can effectively eliminate the deferred taxes.
Because of the complexity and high stakes involved in tax exchange strategies, Arizona Commercial Real Estate recommends our clients seek brokerage and legal advice prior to making a decision to engage in a 1031 tax exchange. ACRE is not a law or accounting firm.
Want to know more about tax deferred exchanges and the different types of exchanges, like reverse or improvement exchanges?
