Avoiding federal tax liability when selling commercial real estate
In most cases, an investor who sells commercial real estate will be required to pay tax on any gain resulting from the sale at the time of the sale. If the real estate has appreciated in value during the investor’s ownership, the tax liability resulting from the transaction can be significant. The Internal Revenue Code, however, provides investors with the means to defer tax liability. One such method is commonly known as a 1031 like-kind exchange.
Section 1031 of the Internal Revenue Code states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
If an investor is able to meet the criteria set forth in Section 1031 and reinvests the proceeds from a sale of commercial real estate into other property of ‘like-kind,’ then the investor is not considered to have received a gain or loss for tax purposes. Instead, the code treats the transaction as a change in the form of the investment as opposed to the sale of the investment.
Like-kind exchanges provide a powerful tool for commercial real estate investors and owners. A 1031 like-kind exchange allows investors to sell appreciated property and reinvest the proceeds in the purchase of qualifying property with no immediate capital gain. While investors may have made a profit on each exchange, they continue to avoid any tax liability until cash is ultimately realized upon the sale of a property. This can also enhance an investor’s buying power by allowing the money that would otherwise be taxed to be invested in the new property.
In effect, a 1031 exchange can act as an interest-free loan from the government for reinvestment and allows the investment to continue to grow tax-deferred.
The following is a very basic summary of the requirements and qualifications of a 1031 like-kind exchange of real estate:
• Qualifying Property. The real estate being sold must be held as an investment or be used in a trade or business. As such, an investor’s primary residence would not qualify for purposes of a 1031 exchange. Similarly, the real estate being acquired must also be used for investment or business purposes. While a 1031 requires that the property be of ‘like-kind,’ for purposes of real estate, the code does not require the real estate being exchanged to be of like grade, quality, nature, character or use. As such, the types of real estate which can be exchanged may vary significantly. That said, to achieve full deferral of tax liability, the new real estate acquired as a part of the exchange must be greater or of equal value to the real estate being sold.
• Timing of an Exchange. For purposes of a 1031 exchange, the sale and purchase of the real estate do not need to occur simultaneously. The code permits the exchange to be delayed for up to 180 days. This provides the investor flexibility and the time necessary to both identify the new real estate and close on it. However, the code does require that the investor identify the potential new real estate (a maximum of three for each exchange) within 45 days, and the investor must not directly receive the proceeds from the sale. Typically, investors engage a qualified intermediary to ensure the investor’s compliance with the code’s identification requirements and to hold the sale proceeds until the closing on the new real estate.
1031 exchanges also enhance an investor’s ability to reposition, rebalance and grow an investment portfolio without immediate tax consequences. Investors can relocate an investment or sell real estate in one location and purchase real estate in a more desirable location. Investors also can convert real estate that does not produce income, such as undeveloped property, into income-producing property, such as retail, office, apartment or other real estate with existing tenants.
Additionally, investors can use 1031 exchanges as a method to diversify their holdings. For example, an owner of residential apartment complexes and office buildings can exchange some of the properties for retail and/or mixed-use properties. In each instance, the investor can achieve the desired result without immediate tax liability.
Given the flexibility of what can be sold and purchased and when, as well as the tremendous tax advantages, 1031 exchanges should be top of mind for anyone looking to alter an existing commercial real estate portfolio. Due to the complexity and constant changes occurring within pertinent tax codes, however, such transactions should always be reviewed by legal counsel with relevant real estate and tax experience.
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