If you’ve successfully invested in commercial real estate, the next step may be to sell the property and cash out. While the thought of pocketing that profit can be tempting, you may also be hit with high capital gains taxes. In order to defer those taxes, you can use the proceeds of the sale to purchase a similar property in what is called a 1031 exchange.
Under Internal Revenue Code (IRC) Section 1031, a business owner, individual or trust may “exchange” a piece of real property (not personal property) for another. Be advised, the IRS has very specific rules regarding 1031 exchanges. Those include:
- The purchased property must be like-kind in nature. This means that the properties being sold and purchased must both be a real estate investment or part of a business.
- The seller must make a like-kind exchange. To receive a 100% tax deferral, the property acquired must be equal to or of greater value than the property being sold. Otherwise, the seller may be subject to depreciation recapture - up to 25% in income tax.
- The exchange must occur within certain time limits. From the date of the sale, the seller has 45 days to identify a replacement property and 180 days to complete the purchase.
- The seller must not take possession of the exchange funds. Proceeds from the sale must be held in escrow by a qualified intermediary (QI) with no financial or personal connection to the seller.
In order to properly perform a 1031 exchange, real estate investors should document everything, create a separate business entity with a dedicated bank account, and of course consult an expert before proceeding. There's no limit to how many exchange transactions you can perform, as long as you perform them correctly.
At Scarborough Commercial Real Estate, we have a large inventory of available investment properties. Before proceeding with a potential 1031 exchange, speak with your financial advisor or tax professional to ensure it is the right course for you.
