1031 Exchanges in CRE
A 1031 exchange can be an effective strategy for optimizing profits on CRE investments. It comes with an attractive tax benefit, which is one of the driving popularity factors of this investment type. By engaging in an exchange, CRE owners can seize new opportunities for wealth accumulation and safeguard their existing equity. Moreover, investors can preserve their stepped-up basis by exchanging into properties with more favorable lease structures, reduced management responsibilities, or passive income generation.
What is a 1031 Exchange?
A 1031 exchange is a tax provision that allows individuals or businesses to sell an investment property and use the proceeds to purchase another comparable property while deferring capital gains taxes. The name “1031 exchange” comes from Section 1031 of the Internal Revenue Code, which governs these transactions.
The purpose is to enable taxpayers to reinvest their funds in a new property without incurring immediate tax liabilities, thereby promoting the continuity of investment and fostering potential growth. Depending on their investment objectives, they can trade their properties for something less management intensive or a property with a higher likelihood of producing more attractive returns.
Requirements to Qualify for a 1031 Exchange
To be eligible for a 1031 exchange, the properties included in the trade must be “like-kind,” which refers to the nature or type of property. This enables investors to defer both capital gains tax and depreciation recapture tax when selling a property and use the untaxed funds to purchase another property of a similar kind.
In order to determine eligibility for IRC §1031 tax-deferral treatment, a two-pronged test is applied. First, both the relinquished property (property being sold) and the replacement property (property being acquired) must be held by the exchanger for either investment purposes or use in a trade or business. The exchanger’s intention and purpose for holding the property is crucial. The involvement of other parties in the exchange, such as the buyer of the relinquished property or the seller of the replacement property, does not affect the qualification.
Second, the relinquished and replacement properties must also be considered “like-kind.” The term “like-kind” pertains to the properties’ nature or character, disregarding grade or quality differences. For instance, unimproved real property is deemed like-kind to improved real property, as the absence of improvements is a distinction in grade or quality.
Matthews™ has handled several 1031 exchanges, one example being a recent multifamily transaction. The owner of a 26-unit apartment building wanted to offload the real estate and cash out after owning the building for seven years. The 1031 exchange buyer was looking to exchange their 10-unit property in an inferior location for a property with more units and a better location. Ultimately, the buyer was able to obtain a property that fit their exchange requirements, and the seller accomplished their goal of cashing out and selling at market value.
Benefits of 1031 Exchanges
Tax Benefits: The opportunity to delay capital gains taxes is one of the key advantages of a 1031 exchange. When an individual or firm sells a property and reinvests the earnings in another like-kind property, the capital gains tax on the profit from the sale can be deferred. This enables investors to keep more of their investment capital and potentially hold more equity.
Reduced Management Responsibilities: Certain assets require higher maintenance, property taxes, insurance, and personnel expenditures. Investors can choose to leave a time-consuming property by trading it for a less time-consuming asset that generates passive income.
CRE Portfolio Diversification: 1031 exchanges allow investors to diversify their CRE portfolio. They can sell a property that no longer meets their investment objectives and reinvest the money in other forms of real estate.
Depreciation: 1031 exchanges allow investors to “reset” the depreciation schedule to a higher value by purchasing a more valuable property. This method provides a significant tax benefit, allowing an investor to boost their after-tax cash flow. This tool is extremely valuable for people who have depreciated their investments completely.
Option to Consolidate or Separate Assets: A 1031 exchange can be used by investors to combine many properties into a single property. This can help to simplify property management obligations while potentially lowering overall costs.
Matthews™ 1031 Exchange Program
The Matthews™ 1031 Exchange Program helps guide investors through the requirements and exceptions in the Internal Revenue Code Section 1031 with the understanding and expertise of Matthews Real Estate Investment Services™. The program is customized to meet investment goals with a step-by-step process that replaces the unknown in the exchange with the confidence that the up-leg investment will directly improve the investment position.