The most common type of 1031 Exchange is used for real estate, likely due to the broad definition of what is considered “like-kind” for Real Estate (or Real Property) Exchanges. In general, any type of U.S. real property held by the client for productive use in a trade or business, or for investment purposes can be exchanged for more real property as long as the properties are of “like-kind”, regardless of grade or quality. The below is a list of properties that are deemed to be of “like-kind”:
For most Real Estate Exchanges, the taxable gain is due to a combination of the appreciation in value and the amount of depreciation taken over the period of time that it was owned by the client. Many investors like to see what kind of tax savings they can benefit from when they sell their investment property. Below is an example which outlines the sale of an apartment building and a purchase of an office building with and without the use of a 1031 Exchange. As you can see, with using the 1031 Exchange the investor benefits from a huge tax deferral. It’s like a “tax free loan from the government” when using a 1031 Exchange creating a stronger buyer position for the purchase.
If you find a replacement property that you would like to acquire before you sell your current property, you can utilize a Reverse Exchange to maximize tax savings. If you would like to build on or make improvements to a replacement property, you can use the exchange proceeds by structuring an Improvement (Build-to-Suit or Construction) Exchange. Also known as “parking” transactions, both Reverse and Improvement Exchanges are two of the more complex yet highly useful exchange structures available.
Reverse Exchanges require an Exchange Accommodation Titleholder (an “EAT”) to hold title to either the client’s old relinquished property or new replacement property pending the completion of the exchange. IRS regulations prohibit an Exchanger from using exchange funds to improve property that the Exchanger already owns. If an Exchanger wants to use exchange funds to improve replacement property as part of a 1031 Exchange, the Exchanger can enter into an Improvement or Build-to-Suit Exchange whereby the EAT takes title to the new replacement property while improvements are being constructed so that the EAT can transfer the replacement property to the Exchanger at the higher improved value.
Selling just one relinquished property and buying just one replacement property is typically what is thought of when contemplating an IRC Section 1031 real estate exchange. Most tax advisors are aware on some level that multiple relinquished or replacement properties can be sold or purchased through an exchange. Investors are typically less aware of this fact. Why don’t we see a greater number of exchanges involving more than just two properties? Most likely the reason why advisors and investors do not utilize the ability to sell or purchase multiple properties is because they are thinking solely in linear terms – sell one property and buy one property. Most people have enough on their plate with one relinquished property and one replacement property. However, a powerful investment tool emerges when using exchanges with three or more properties involved.
Selling a relinquished property for $500,000 and then buying a replacement property for $500,000 or more is the typical way we think about exchanges. If we move beyond this “one-to-one” idea, we realize that we can take advantage of multiple types of market opportunities. For example, you may be an investor who has a number of smaller rental units each worth $100,000. They have been good investments, but now you have an opportunity to buy a larger commercial mixed-use property. It’s a good deal, but how do you fund it? Simple – sell a few of your rentals.
Some investors will choose to bundle the properties for sale, while others will sell them one at a time. Buying multiple properties works the same way. Some of the best real estate opportunities are in foreclosures and short sale properties. You may own an office building or retail investment, 90%+ rented, that is worth $500,000 and buyers are plentiful. In order to take advantage and buy some of these foreclosed or short sale properties, you could sell your office building and buy five or six distressed properties. It is a harder concept to grasp because most investors are trying to buy up. They are not typically thinking about selling and dividing the income into less costly assets. This method allows for numerous benefits such as diversifying into multiple properties and use of a value-added strategy. Although we will intentionally avoid an in-depth discussion of all the laws and regulations that surround exchanges in this short article, it is important to mention the identification rules.
These rules define the number and value of properties that can be identified for purchase in an exchange. In essence, these rules limit your ability to make general and unlimited identifications. You can always identify up to three potential replacement properties without regard to their value. If you identify more than three, then the total aggregate value of all properties identified may not exceed 200% of the total value of the relinquished properties in the exchange.
Before contemplating an exchange, it is important to speak with your tax advisor and plan out your strategy. This planning phase is paramount to ensure success when contemplating an exchange with three or more properties. If done correctly, exchanging with more than just two properties can be implemented into your investment strategy and can create greater opportunities and rewards.
6926-B Little River Turnpike
Annandale, Virginia 22003
965-C Russell Avenue
Gaithersburg, Maryland 20879