As commercial real estate investors look to build wealth for the long-term, many turn to the 1031 Exchange, a common vehicle used to defer capital gains and related federal tax liabilities. The U.S. tax code allows investors to sell property and buy “like kind” assets as part of a 1031 Exchange to defer capital gains.
This is a valuable means for building wealth, yet it is often misunderstood. If the timing, structure and requirements are not followed, the result could be detrimental -- saddling investors with capital gains liability and newly purchased investment property that is not suited to their goals.
Here are ways to avoid common mistakes with 1031 Exchanges.
“Tax deferred” does not mean “tax free,” for example. A 1031 Exchange allows investors to defer capital gains of 20 to 30 percent, depending on their tax bracket, and roll those gains into the next property. Eventually, when the property is sold without a replacement, the capital gains liability will kick in. This is typically timed to occur after many years of building wealth, when the investor is in retirement and/or in a lower tax bracket.
There are many requirements to a 1031 Exchange -- from legal language in the contracts to the timing of filing documents and buying real estate to replace the asset sold. Any missteps could jeopardize the 1031 status and leave an investor in a no-win situation as the clock ticks down to closing. When interviewing brokers, ask for details about their experience with 1031 Exchanges, including obstacles they have faced and the team of accounting, legal, title and related professionals they will assemble to navigate the process.
It can take time to find the right asset, so start ahead of closing on the sale, which triggers a 45-day timeline for identifying the new asset. The goal is to find the right asset and avoid coming up on a deadline and having to quickly purchase a less desirable property or pay capital gains.
1031 Exchanges can be completed using any asset class. Some commercial real estate investors assume that “like kind” means the same asset class, however, and they narrow their search accordingly. This can lead to missed opportunities or buying an asset that will not provide the desired return. Experts also caution investors to look at the whole picture, including investment horizon and other factors outside of the capital gains benefits, according to Kiplinger’s.
Investors should spend at least three to four months researching a market, ideally with the assistance of an experienced broker. This will help with understanding market fundamentals and allow for making decision from a position of strength.
When trading an improved property, commercial real estate investors may have to recapture the portion of the gain on the sale related to depreciation.
The 1031 Exchange is a valuable tool for helping investors build appreciation and long-term value, but it should be approached with an inquisitive mind. By planning ahead, finding the right resources, and being aware of all the nuances regarding timing and contractual issues, investors will be in the best position to move forward.