If you own commercial real estate that has increased in value since the 2008 recession and are thinking about selling it now to cash in on its increased value, you might want to consider the advantages of reinvesting your profits via a 1031 exchange.
1031 exchanges – also known as tax-deferred exchanges – allow you to defer the capital gains and other taxes you would owe on the profit from the sale of one piece of property by reinvesting those profits in an IRS-approved replacement property.
To illustrate the potential tax benefits of a 1031 exchange, consider this hypothetical example:
- You own a piece of property that could yield a $200,000 profit at the time of sale.
However, your tax liability on this property would be approximately $70,000 after paying federal and state capital gains taxes and depreciation recapture taxes.
- After taxes are paid, your net profit would be reduced to just $130,000.
- If you chose to reinvest your profits in an IRS-approved “like kind” piece of real estate, however, you could invest the entire $200,000 profit in this other piece of real estate and defer the taxes owed.
- Assuming a 25% down payment on the new property, you could invest the $200,000 profit in real estate valued at $800,000.
Many investors are using 1031 exchanges to exchange a property that requires a lot of work and expense to manage for commercial properties that have high-credit tenants on long-term leases. These kinds of properties reduce the likelihood that the property owner will be burdened with a vacant property or need to look for a new tenant.
Commercial property investors who take advantage of 1031 exchanges throughout their lives can realize significant increases in their net worth over time. If you will your property to your children, then your children can benefit from the stepped-up cost basis for your real estate investments and potentially be exempted from all tax obligations on those properties.
Of course, 1031 exchanges are a sophisticated wealth management strategy that should only be undertaken under the guidance of experienced tax advisors and real estate experts. If you do not understand or comply with IRS rules governing these exchanges, you could end up owing the government more than you expected.
For example, you’ll want to have a thorough and accurate understanding of the IRS’ definition of “like-kind” property. This definition is often mistakenly thought to mean the same exact types of property, but there may be many investment possibilities that only an expert would understand.
Timing your real estate exchange properly is another crucial consideration. From the time your property sells, you have 45 days to identify a property you are interested in, and 180 days to complete that purchase. Otherwise, the proceeds from the sale become taxable.
The time to start thinking about an exchange is when you’re ready to enter into a contract with a buyer. You need to make sure you allow enough time to identify a like property that you’re interested in, and you’ll want to make sure your contract includes provisions that prohibit your buyer from delaying the closing date and undermining your ability to purchase your new property in compliance with IRS deadlines.