1031 Exchanges: A Go-To Strategy for Businesses and Investors

Real estate transactions are showing no signs of slowing down, and part of the reason is a popular section of the tax code known as a 1031 Like-Kind Exchange.

Exchanges are go-to strategies for businesses looking to upgrade or relocate facilities, and investors moving upstream, into newer properties, or into different sectors. The 1031 Exchange allows taxpayers to sell properties and buy new ones without paying taxes on the profit from the sale.

This tactic works by exchanging real property used for business or held for investment, using the proceeds to purchase business or investment real property of a “like-kind”. To the extent proceeds from the sale are reinvested in the replacement property, and the debt incurred on the replacement property is at least equal to debt on the relinquished property, no gain is currently recognized. With the right advice from a real estate accounting firm, such a swap can be the perfect solution for businesses or investors looking to reposition their real estate holdings.

Businesses are using 1031 exchanges to move up in physical, technological or logistical capabilities not available in their old facilities. Exchanges are also being used to relocate to entirely new markets, or to shift excess capacity from concentrated areas to underserved markets. Exchanges may also be used to replace one type of property for another, such as an office building for a warehouse. It can also be part of a strategic plan to change businesses altogether. For example, a farmer transitioning from farmland to apartments.

Investors are taking advantage of 1031 exchanges to change their realty holdings for various reasons. For example, an exchange of unproductive land for commercial buildings in order to generate cash flow. Land may generate liquidity when sold, while commercial buildings generate rental income potentially sheltered by depreciation. Investors may also increase diversification with an exchange allowing them to trade property concentrated in certain markets (geographic, segment, size) for properties in different markets. Because there are no limits to how many times a taxpayer may rollover gain from 1031 exchanges, they are often part of a taxpayer’s estate plan. It facilitates growth on the gross equity over time, without reduction for taxes, thereby yielding a higher return. If the exchange property is held in the estate at the taxpayer’s death, the 1031 gain deferrals are often eliminated with the resulting basis step-up, allowing heirs to subsequently dispose of the property without income tax.

An experienced CPA with expertise in real estate can help you manage all the nuances, timing and other requirements in order to qualify under 1031. These include requirements such as a 45 day time period to identify potential replacement properties, a 180 day time period from sale to acquire the replacement property, a prohibition for taxpayer to have receipt of sale proceeds, an intention to hold the property, certain related party rules, and definition of like-kind. With such a tight calendar and so many points to negotiate, it’s critical for taxpayers to prepare in advance when embarking on a 1031 Exchange.