How to Use a 1031 Exchange to Grow Your CRE Portfolio

Capital gains taxes can eat up your proceeds when you sell a commercial property. But there are strategies you can use to reduce those costs, scale your investment and maximize long-term returns. It’s called a 1031 exchange, and it can be an effective tool in your arsenal when done properly. Learn about the rules and timelines.

What is a 1031 Exchange?

It’s a tactic that allows you to defer capital gains taxes when selling an investment or business property. The name refers to Section 1031 of the Internal Revenue Code that outlines the regulations for those transactions. When completing this type of exchange, you must sell your current or relinquished property and purchase replacement real estate.

1031 Exchange Rules and Requirements

Like-kind property: Your relinquished and replacement properties must be considered “like-kind,” which means the nature of their use must be similar, but their industries can differ. For example, you can sell a multi-family property and use those funds to purchase an industrial warehouse if it’s of equal or greater value.

Location: Like-kind properties must be located within the United States.

Business or investment use: Both assets’ intended uses are for rental income, business operations or capital appreciation. You cannot complete a 1031 exchange on primary residences, second homes or vacation homes.

Value and debt replacement: The replacement property should be of equal or greater value to your relinquished real estate.

Qualified intermediary: You must hire a qualified intermediary (QI) to hold onto the funds from the sale of your relinquished property. If you receive any money during the transaction, the IRS will consider it a taxable sale.

Timelines: After you sell your current property, you have 45 days to identify up to three potential replacement options. A concurrent timeline also begins during which time you have 180 days to close on one or more of your chosen replacements.

Types of 1031 Exchange Properties

Office space: Whether you use a location for your business or rent it to tenants, office spaces are designed for commercial use and therefore qualify for a 1031 exchange.

Retail properties: This type of property includes strip malls, stand-alone stores, shopping centers and restaurants.

Industrial facilities: Any space used for production, manufacturing or specialized operations is considered a commercial industrial facility.

Warehouses: Real estate used for distribution, logistics and supply-chain operations qualify as warehouse spaces.

Multi-family housing: Residential properties that offer housing for multiple renters and generate ongoing income are common assets used in 1031 exchanges.

The Benefits of Using a 1031 Exchange

A 1031 exchange is one of the most effective tax-deferral tools available to commercial real estate investors. You can protect the equity you’ve built in your current property without having to pay taxes during the sale. You may continue to compound those gains and diversify your asset portfolio across different industries and areas. However, it’s important to remember that this process doesn’t eliminate taxes, and you’ll have to pay once you sell without reinvesting.

You can shift to more passive investments when you complete a 1031 exchange, allowing you to simplify management and maintain quality returns. If you wish to transfer your assets to heirs upon your death, they can have the property adjusted to the current market value and can sell it tax-free.

Common Mistakes Made during a 1031 Exchange

Missed deadlines: Failing to identify and close on a replacement property within the allotted periods is a common error. Planning for deadlines before you sell can help you avoid wasting time.

Receiving proceeds: Ensure your contracts specify that all proceeds and funds go to a designated third party or QI.

Selecting the wrong property: Verify the replacement property is evaluated and used for business or investment before completing a purchase.

Documentation issues: Be sure to identify your replacement property to the IRS by providing receipts, rental agreements and business records.

Mismanaging boot: Any debt reduction caused by your purchase is considered taxable income. Ensure your replacement property debt is equal to or greater than your relinquished property.

Working without an expert: The precise nature of this type of investment exchange requires expert knowledge. Partnering with a QI, real estate attorney or tax professional can help you reduce your risk of error.

Selling the replacement: You must hold onto a replacement property for a few years before selling or the government will consider it a flipped asset.

When to Avoid a 1031 Exchange

There are scenarios in which completing a 1031 exchange can be detrimental to your strategy. Exchanging properties with declining values or low equity could result in reduced ROI and fewer capital gains. Because you can’t acquire proceeds until the process is complete, you may not want to pursue this tactic if you need cash quickly. Furthermore, you may reconsider completing an exchange if the fees and legal costs outweigh the total deferred taxes.

Expert CRE Investment Services in Columbus, Ohio

Navigating the legal side of commercial real estate can be tricky. That’s why it’s effective to partner with a team of experts who know the Columbus market like the back of their hands. DRK and Company specializes in CRE investment and management, so you can count on us to optimize your portfolio. Contact us to learn more about our services.