1031 exchanges are named after the IRS code’s section 1031. This term is often used by title companies, realtors, investors, and many others. In some cases, people use the term “1031 exchange” as a verb rather than a noun. Other words that people use for a 1031 exchange include starker and like-kind exchange. Here are a few things worth knowing about this exchange.
- 1031 exchanges entail swapping properties for business or investment purposes
- The IRS must see exchanged properties as like-kind to defer the taxes for capital gains
- There are no caps on the number of times you participate in or utilize 1031 exchanges
The phrase “like-kind” may not be obvious to everyone. Contrary to popular belief, it is not too focused on the particular purpose of a property. Instead, it is more interested in the purpose of the investor. Generally speaking, one can freely exchange a property that generates profits in favor of another. You can also exchange one business for the other.
This essentially means that you will be well within your rights if you exchange a farm for a strip mall or a medical facility for an undeveloped piece of land. While all of these properties serve different types of sectors, property owners still consider them to be commercial properties.
Can 1031 Exchanges be Beneficial for Real Estate Investors?
Whenever someone sells a property, all of the proceeds they get from it are taxable. When it comes to 1031 exchanges, transferring said proceeds to professional intermediaries rather than yourself will allow you to reinvest these proceeds to acquire new property.
What’s more, making use of 1031 exchanges can help you get out of an older house without losing massive amounts of money, something that commercial real estate investors can especially benefit from.
The Role of Qualified Intermediaries in Like-Kind Exchanges
The CPA journal suggests that more than a quarter million people file for 1031 exchanges every year. With more people becoming aware of the benefits offered by 1031 exchanges, this number is increasing quite rapidly, and because of this, a massive industry of qualified intermediaries has popped up in recent years. These intermediaries are individuals or businesses that facilitate these exchanges as they hold the funds for the transaction, which they transfer to the replacement property sellers.
It is worth keeping in mind that the role of a qualified intermediary does not go beyond what is mentioned above. These professionals do not have permission to create other formal relationships with any party exchanging property.
Entering the World of Commercial Real Estate
Many real estate investors tend to begin with residential properties and there are two reasons behind it:
- The entry costs are quite low
- Dealing with residential properties is relatively straightforward
However, once real estate investors have enough resources, they consider entering the world of commercial real estate. This is where a 1031 or like-kind exchange can prove to be helpful. Consider a situation where a real estate investor has a portfolio with multiple duplexes and tenants that provide rental income. Also, assume this investor is considering having an office building that only has one tenant. In such a case, utilizing the 1031 exchange of the duplexes to get a single replacement may offer multiple benefits for commercial real estate investors. These include:
- Commercial real estate is often more lucrative if investors approach it correctly
- Investor’s cash flow increases because the involvement of a property management company will not be necessary
- There are no maintenance costs involved as the tenant assumes the responsibility in matters like these. In some cases, the tenant may even take care of insurance, property taxes, and other burdens
Investors holding properties that do not generate any revenue can utilize 1031 exchanges to their benefit. Imagine you are the owner of underdeveloped structures or land without any tenants. You have the option of freeing yourself from properties that don’t create revenue. One of the best things about these exchanges is that you can create decent passive income streams by merely rearranging the properties you own and not losing your asset’s overall value.
Things Commercial Real Estate Investors Must Keep in Mind about 1031 Exchange
It Can Offer You Leverage
Using a 1031 exchange is an excellent way for commercial real estate investors to upgrade their investment options. What’s more, since you will not be paying money for capital gains taxes, making bigger down payments will become easier. All of this will increase your purchasing power, especially if you want to purchase an expensive property.
Consolidation Becomes Easier
Some commercial real estate investors find their portfolio to be too thin and they may want to simplify things for themselves. In cases like these swapping multiple properties in exchange for one can be quite helpful. Alternatively, investors can also swap 3 or 4 in exchange of 2 properties.
Efficient Diversification
You are free to use 1031 exchanges anywhere in the U.S. You can even swap the properties you own in sinking or repressed markets in exchange for those located in areas that offer excellent growth. What’s more, real estate investors can choose from a variety of local markets across the United States, which is an excellent way of converting single properties to multiple real estates, resulting in more streams of income.
Don’t Forget About the Deadlines
If you want to qualify for a like-kind or 1031 exchange, you must be able to identify 1 to 3 properties within 45 days. What’s more, the exchange must take place during the following time periods:
- The first three months after selling the property (the original one)
- The original property sale’s tax returns due date
Considering how punctual you have to be with such transactions, working with a professional could help you purchase properties using 1031 exchanges quickly and efficiently.