What's a 1031 Exchange and How Can It Work for a Real Estate Investor?

February 11, 2019

Real estate investors can defer taxes when they sell real estate investment properties and quickly re-invest the proceeds to buy other real estate assets.

The so-called 1031 Exchange—which gets its name from that section of the federal tax code—is one of the most important tools that long-term investors in real estate use to defer their tax burden, according to Greystone, a leading commercial real estate finance company that lends to investors often completing 1031s. However, in order to qualify for the tax benefit, the proceeds of the sale of real estate need to be re-invested within a strict timeframe.

Greystone's deal experts, such as loan originator Anthony Cristi, notes that it's important to work with a lender like Greystone who can provide certainty of execution, so that the investor can be confident that their deal will close on time to qualify for the tax benefit.

How the 1031 Exchange Works

The 1031 tax benefit allows investors to put off paying capital gains taxes on the sale of real estate property if the proceeds are quickly reinvested in a similar property. Investors will eventually have to pay their deferred taxes, if they take their money out of real estate during their lifetime. In the meantime, the so-called “like-kind exchange" allows investors to earn a yield on those gains, as long as they stay invested in the real estate.

Through a series of like-kind exchanges, investors can potentially trade properties many times while deferring the payment of capital gains. Investors who keep money invested in real estate throughout their lives could potentially pass those properties on to their heirs after their deaths without ever paying capital gains on the appreciation of the value of the property during their lifetime.

To qualify as a like-kind exchange, the property sold and the property purchased need to be roughly similar, such as commercial-use properties. That means that a strip mall can be exchanged for a multifamily apartment building, or a vacant lot can be exchanged for a medical office property and still qualify. To qualify, the property needs to be held for investment or used in trade or business—the use of a 1031 exchange for property held for personal use was eliminated under the federal Tax Cuts and Jobs Act of 2017.

Qualifying for the Tax Benefit

To qualify for the tax benefit, the proceeds from the sale of the first property need to be reinvested before too much time passes. An investor has 45 days after selling a property to identify the similar real estate property they plan to acquire. The acquisition will need to close within 180 days of the initial sale.

Typically, the investor must close on the sale of the first real estate property before the purchase of the new real estate property. If the investor purchases the new property before the sale of the old property is completed, they may still be able to defer their capital gains through a “Reverse 1031" - though this process comes with added cost. Investors should work with a qualified tax advisor if they are planning a Reverse 1031 exchange, to ensure their deal qualifies for the tax benefit.

To qualify for full deferral, the value of the real estate property acquired by the investor must be equal to or more than the value of the like-kind property sold by the investor, including any debt on the property.

The whole process is transacted through a qualified 1031 intermediary—an entity required to hold the money from the sale of the first property separately from the investor's other assets. A qualified 1031 intermediary can also help the investor make sure that their deal fully qualifies for the tax benefits.

Your real estate attorney or lender may be able to refer you to this type of intermediary to ensure a smooth 1031 exchange. The long-term benefits of this program are certainly worth exploring when buying and selling investment properties.

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