Written By Brant Baylock
Commercial and investment real estate is a fantastic way to build wealth for a number of reasons: You can purchase an appreciating asset with the leveraging power of financing, then take a deduction against the total investment value in the form of depreciation, and presumably earn a return as long as you own the asset.
However, if you decide to sell that asset, there will be tax consequences that could prevent you from “trading-up” with your capital intact, especially if you’ve owned it for a number of years.
Fortunately, if you want to replace the asset that you are selling with another asset of equal or greater value, there is way to delay or “defer” these taxes by using a rule tax rule that’s been carved out for investors, under IRC Section 1031, commonly referred to as the Like-Kind Exchange.
The IRC Section 1031 Like-Kind Exchange allows an investor to “defer” the taxes on gains from the sale of a business or investment property, provided that investor reinvests his or her proceeds into a similar asset. In the case of commercial or investment real estate, a similar asset simply means one investment property for another. It does not matter what type of property you are holding, as long as it has earned income, or been used to conduct business. *Note that primary or secondary homes do not qualify, unless the home has been held in use of trade or business, or for investment purposes.
Fortunately, one can conceivably postpone the taxes forever, as there is no limit to the number of times that investor can utilize this tool.
What taxes can I defer?
In the case of commercial or investment real estate, the two types of taxes on the sale of a property are Capital Gains, and Depreciation Recapture.
Capital Gains are the realized profits from the sale of a capital asset; in this case, investment real estate. The current tax code (which will likely change soon) depends on the investor’s income for the year the gain is realized. It currently ranges from 0 to 20% for assets held longer than 1 year. Alternatively, if the asset is held for less than a year, short-term capital gains are taxed at the same rate that the investor pays for ordinary income.
Depreciation Recapture is more in-depth. Real estate Depreciation allows investors to take a deduction against the value of their real estate asset in equal installments over a period of 39 years for commercial real estate, or 27.5 years for residential real estate, including multifamily. The depreciated value of the property then becomes the basis at the time of sale.
Let’s say you purchased a property worth $1,225,000. To find the original basis, you would subtract the price of the land from the price of the improvements, which are the structures on the property, including any capital investments you’ve made during the term you’ve owned the asset. It’s important to note that land cannot be depreciated, since it doesn’t lose value, but all the improvements on the land can.
In our example, let’s assume the land value is $225,000, and the value of the improvements are valued at $1,000,000. So, $1,225,000 - $225,000 = an original basis of $1,000,000. However, if you’ve owned the asset for a number of years, the property has been depreciated, and the basis has been reduced.
When the commercial or investment real estate asset is sold, the difference between the basis and the total capital investment must be reported as depreciation recapture in the year the sale was made. That’s when Uncle Sam says, “I gave you a break on your taxable income through depreciation, and now I want some of that back.”
Let’s try another example, and consider both capital gains, and depreciation recapture:
You originally bought a commercial or investment real estate property for $1,000,000. It’s been a great investment, and after 20 years, you’re ready to sell. Your broker tells you that your property will fetch $3,000,000, net of all closing costs. Now you can sell your property, and ride-off in the sunset, right? Well, first, Uncle Sam will want his share.
First, you would have to pay capital gains taxes on the profits from the sale. Since you originally purchased the property for $1,000,000, and are selling it for $3,000,000, you will have $2,000,000 in capital gains, which under the current tax laws, will be taxed at 20%.
In addition to capital gains, you would also have to pay a depreciation recapture rate of 25%. Since you have owned the property for 20 years, and have depreciated the property approximately $20,000 per year, your adjusted basis is approximately $600,000. This means that you will have to recapture $400,000, and it will add $100,000 to your tax burden.
In addition to federal taxes, you may also be looking at state tax if you’re not from an income tax-free state like Florida, which could be as much as 13.3%!
Unfortunately, all this could make your tax liability so massive that it wouldn’t make any sense to sell. If you’ve ever heard an owner say that he or she can’t afford to sell because of tax reasons, this is the reason why.
This is where the 1031 tax deferred exchange strategy comes into play. Instead of paying taxes now, you can defer those taxes into the future (perhaps forever), and use the entire $3M to grow your portfolio.
How Does the 1031 Exchange Work?
Going back to our example, your $3,000,000 property will be referred to as the relinquished property. You will first need to engage a Qualified Intermediary (QI) to hold the proceeds from the sale until you close on your replacement property. The intermediary will collect and disburse all funds from the beginning to the end of the process.
Time will also be a critical factor in the process of your exchange. From the day the relinquished property is sold, you will have a total of 180 days to complete the 1031 exchange process. The first 45 days is known as the identification period, in which you must identify at least one property to purchase within 180-days of selling your relinquished property.
You can choose one of three ways to identify a replacement property, all of which must be delivered to the QI no later than the 45th day:
The most common is the 3-property rule. This rule states that you must identify up to 3 properties, and the replacement property’s debt must be greater than that of the relinquished property.
The second rule is the 200% rule, where you may identify as many properties as you like, but their value cannot exceed 200% of the relinquished property.
The last rule is the 95% rule. This is where you may identify as many properties as you like, but you must purchase 95% of the value of all the properties you identified.
Day 46 would mark the remaining 135 days to complete the purchase. And yes, these rules and timelines are written in stone.
It is also important to note that your replacement property must be equal or greater value in order to defer all the taxes from the sale of your relinquished property. If not, there will be a “boot,” or residual amount that will be taxable.
The 1031 Like-Kind Exchange is a powerful tool to help investors keep their capital intact while they build their wealth through investments in commercial and investment real estate. However, there are some very specific requirements, and rigid timelines that must be followed in order to be successful.
If you are in considering the acquisition or disposition of an asset, and you need assistance with your 1031 exchange, along with the process of locating and acquiring a replacement property, call Sperry Commercial Global Affiliates – Flint Brokers & Associates for a consultation. The Sperry CGA – Flint Brokers' team serves as expert commercial real estate advisors to owners and investors across a broad spectrum of industries. By combining our in-depth local market knowledge and connections, with the broad reach of our global affiliate network, and our utilization of the latest technologies, we are able to deliver strategic, targeted solutions to our clients, with integrity and professionalism.
For more information, visit www.flintbrokers.com.
*This article is meant to provide general information, and cannot be assumed to apply to every situation. Please consult your tax or legal advisor for information about your particular circumstances.