There are few certainties in life, but one inevitability of the modern age is our obligation to pay taxes and the desire of some (perhaps many) to defer or reduce this obligation. In the world of commercial real estate, the “1031 exchange” can provide one critical avenue to defer paying capital gains tax on the sale of an investment property.
I am based in New Jersey, where the 1031 exchange is a popular vehicle used to defer paying taxes on capital gains via real estate. While my hope is to share some basic guidance on the 1031 exchange process, they are complex so you should confer with your local real estate attorney and real estate advisor before engaging in a 1031 exchange.
What is a 1031 Exchange?
Section 1031 of the Internal Revenue Code allows the owner of a real estate investment property to defer paying capital gains by reinvesting money from the proceeds of the property sale into similar or “like kind” investment property. This is because, from a tax perspective, you’re changing the form of your investment without recognizing a capital gain.
Thousands of real estate investors, if not more, are taking advantage of this every year. It’s a simple solution to deferring payment of capital gains tax, but there are certain restrictions that might alter whether or not you can take part in a 1031.
How long do I have to identify a new property?
The taxpayer must identify the “like kind” replacement property within 45 calendar days of closing on the sale of the relinquished property. According to Daniel Madrid, a partner with Fox Rothschild LLP’s real estate practice, there are limited exceptions to these rules and each should be understood and strictly followed to avoid forfeiting the intended benefits of the 1031 exchange.
Can I identify more than one property as replacement property?
Here’s the good news: While the taxpayer has a 45-day period in which to act, the rules permit the taxpayer to identify more than one replacement property. However, the taxpayer is limited by two rules: the “Three-Property Rule” and the “200% Rule.”
The “Three-Property Rule” allows the taxpayer to identify up to three replacement properties without any limitations as to the fair market value of such properties. The “200% Rule” gives the taxpayer the ability to identify an unlimited number of replacement properties as long as the aggregate fair market value of the replacement properties at the end of the identification period does NOT exceed 200% of the value of the property being sold.
So, you can either identify up to three properties without regard to cost or you can identify an unlimited number of properties as long as their value is less than double the value of the property you sold.
How long do I have to close?
The rules here are strict as well. The taxpayer has 180 days from the closing of the initial sale to close on the purchase of one or more of the properties identified during the initial 45-day identification period. Closing occurs when the title of the property has passed.
Don’t be fooled though — the 180-day period begins at closing of the original sale. In other words, if you take all 45 days to identify your replacement property, you’ll only have 135 days left to close.
This is a quick, bare-bones overview of how a 1031 exchange works, but there are many more details to the process. If you’re interested in potentially taking advantage of the 1031 exchange, please confer with your real estate attorney and advisor so they can advise you on all aspects of the exchange.
Based in Princeton, N.J., Vinny specializes in tenant and landlord representation for Colliers International, working directly with his clients in the acquisition and disposition of office space. For more commercial real estate insight and trends, follow Vinny on Twitter.