A.CRE

1031 Exchange

A common real estate practice with origins in the IRS code section 1031, which allows investors to essentially swap one property for another in an effort to defer capital gains taxes. The two properties must be “like-kind” properties and used in a trade or business as an investment. 1031 exchanges must meet multiple other requirements. If executed successfully, however, investors can save large amounts via deferred capital gains taxes, which helps spur ongoing investment.

Putting 1031 Exchange in Context

Consider the scenario involving Thompson Real Estate Holdings, a seasoned real estate investment firm. The company owns a commercial office building in downtown Jacksonville, Florida, valued at $2.5 million. With the goal of diversifying their portfolio and relocating capital into a more lucrative market, they are interested in a retail shopping center in Atlanta, Georgia, valued at $2.7 million.

To facilitate this transition without incurring immediate capital gains taxes, Thompson Real Estate Holdings decides to engage in a 1031 Exchange. Both properties are classified as “like-kind” since they are investment properties not held primarily for sale. Here is how the exchange is structured:

  1. Identification of Replacement Property: Within 45 days of selling the Jacksonville office building, Thompson Real Estate Holdings must formally identify potential replacement properties, including the Atlanta shopping center.
  2. Closing the Exchange: The entire transaction must be closed within 180 days of selling the initial property. This means completing the purchase of the Atlanta shopping center within this timeframe.
  3. Utilizing a Qualified Intermediary: To ensure the process adheres to IRS regulations, they employ a Qualified Intermediary (QI). The QI holds the proceeds from the sale of the Jacksonville property and uses them to purchase the Atlanta property, ensuring that the funds do not pass directly to Thompson Real Estate Holdings and potentially disqualify the exchange.

By successfully executing this 1031 Exchange, Thompson Real Estate Holdings defers recognizing over $375,000 in capital gains taxes, which can now be reinvested into the newly acquired property. This strategic move allows the firm to leverage their capital more effectively, increase their investment in a burgeoning market, and ultimately enhance their portfolio’s profitability.

Frequently Asked Questions about the 1031 Exchange

 

A 1031 Exchange is a real estate practice based on IRS code section 1031, allowing investors to “swap one property for another in an effort to defer capital gains taxes.”

“Like-kind” properties are defined as those “used in a trade or business as an investment” and are not held primarily for sale. Both properties must serve investment purposes to qualify.

Within 45 days of selling the initial property, investors must “formally identify potential replacement properties.” This is a strict IRS requirement.

The entire exchange transaction must be completed within 180 days of the sale of the original property. This includes the purchase of the replacement property.

A Qualified Intermediary (QI) is used to “hold the proceeds from the sale” of the original property and facilitate the purchase of the replacement. This ensures that the investor does not receive the funds directly, which could disqualify the exchange.

If executed successfully, a 1031 Exchange allows investors to “defer recognizing over $375,000 in capital gains taxes,” enabling reinvestment into the replacement property and enhancing long-term profitability.

Yes, as long as both properties are held for investment or business purposes, they are considered “like-kind.” For example, the exchange of an office building for a retail shopping center is valid.

They sold a commercial office building in Jacksonville for $2.5 million and used a 1031 Exchange to acquire a retail shopping center in Atlanta for $2.7 million, deferring capital gains taxes in the process.

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