You might have heard that the current rules for 1031, or like-kind exchanges for commercial real estate are in the spotlight for potential legislative changes in the very near future. 1031 exchanges have been around since 1921 and have been a significant benefit for commercial real estate investors who are seeking to diversify their real estate portfolio or want to move past the active management of those assets.
We have worked with our clients and qualified intermediaries to help real estate owners think about their options when they are “relinquishing” a property and looking for a “replacement” property. Relinquish and Replacement are the terminology of 1031 exchange transactions. Prior to the 2017 Tax Cut and Jobs Act, you
could do like-kind exchanges in a variety of commercial assets including art and equipment. However, now the option is only available for commercial real estate and the current administration is considering eliminating benefits for gains over $500,000 for individuals and $1,000,000 for couples.
Most people think about the exchange transaction as a sale and purchase. However, you can also do a purchase then sale. This transaction is called a “Reverse 1031 Exchange.” Recently I went through one of these transactions for my personal situation allowing me to get a front row seat to some of the complexities that you need to consider and the twists and turns that you will face along the way.
Essentially, if you find a property that you would like to buy and believe that you have property(a) that could ultimately sell to finance the purchase, you may consider a reverse 1031 exchange. Like all 1031 exchange transactions, you must be prepared before closing to have a “qualified intermediary” involved so that you never take possession of the sale proceeds. As you might guess, these transactions could relieve substantial current tax obligations, so the internal revenue service scrutinizes them at a higher level. As such, having the right team on board as you contemplate your alternatives is crucial to a successful transaction and no future surprises.
In my case, I bought a commercial office building which required that I come out of pocket for the down payment and borrow the remainder. I engaged a qualified intermediary before this transaction who set up a new entity which received the proceeds from three other buildings that I sold with tangible embedded capital gains as well as recapture obligations. There are very specific rules about timing and procedures to do this correctly, which is why a team is so important.
Since we have been experiencing a very active real estate market lately, I had confidence that my three residential commercial properties would sell rather quickly and within the 1031 allotted time frames. At the end of the transaction, I avoided significant Federal taxes and paid down a significant amount of the acquisition debt as well as receiving a refund of my down payment. Please be aware, Pennsylvania is a state that does not recognize 1031 exchanges so the 3.07% tax in Pennsylvania will be paid.
Care needs to be taken in each transaction because a “like-kind” exchange requires that the replacement property have the same structure as the relinquished property. There are a variety of other ownership, debt structure and timing rules which require appropriate advice that are beyond the scope of this article.
In my situation, the gross value of the relinquish property exceeded the purchase price of the replacement property. As such I had something called “boot”. Typically, you would simply pay the taxes on the boot, or excess portion but there is another alternative. You can acquire a fractional interest in a Delaware Statutory Trust (DST). These programs are provided by a variety of companies, but we typically limit our exposure to national firms that do not use more than 50% to 60% leverage.
In my case I put the boot into a Delaware Statutory Trust allowing me to avoid all federal taxes on the capital gains transactions. As I see it, my ability to defer the taxes has allowed me to finance the renovations that I needed on the replacement property. Again, this worked out well for my situation but there are significant complexities that need to be understood before you go into the transaction because you will deal with them along the way.
If you’re contemplating selling commercial real estate, or buying commercial real estate then replacing it with currently held commercial real estate, these transactions may be of interest to you. The real estate market is very active these days and owners may consider these tax planning strategies while they are still available.
As mentioned earlier, it is important to get the right advice and the right team on your side to be sure that you understand the rules and can take advantage of a 100-year-old 1031 tax provision that again finds itself under the legislative magnifying glass. Feel free to contact us at 888 PLAN GR8 so we can help you think about your options pre-transaction, so that you don’t have any regrets post transaction.
By the way, we hope to meet soon, or at our new office once the renovations are complete.
Emrich M Stellar, Jr., ChFC, CLU, CBEC