What is a 1031 Exchange?

Trying to understand common commercial real estate terms can sometimes feel like deciphering a foreign language. What is a 1031 Exchange, Cap Rate, Core Factor, Triple Net Lease, or Tenant Improvement Allowance (TI)? It’s enough to make your head spin. But it’s important to know these terms and more when navigating the often-complicated world of commercial real estate investment.

In this article today, we’re going to cover one of these terms – 1031 Exchange.

What is a 1031 Exchange?

Time and time again, we hear the same question. What is 1031 Exchange? How does it work? And how will it affect my investment strategy?

To help you better understand the intricacies of 1031 Exchange, here’s United Development Realty Founder and CEO Charles Peacock as part of our What’s That Wednesday short video series, which tackles frequently asked questions about the commercial real estate market.

Charles Peacock: What is a 1031 Exchange? Sometimes referred to as a like-kind exchange, a 1031 is a strategy that’s been around for 100 years that investors use to defer taxes. Whether delayed or reverse exchanges, the investor is selling one property and buying another. There are some strict rules to qualify for the transaction, including using a facilitator called a qualified intermediary. When done properly the 1031 can be an important strategy to building and preserving wealth. Investors should work with their experienced broker to navigate this transaction successfully. If you’d like more information please reach out to us. We’re here to help!

Understanding 1031 Exchange & How It Works

The term gets its name from Internal Revenue Service (IRS) code Section 1031.

“In real estate, a 1031 exchange is a swap of one investment property for another that allows capital gains taxes to be deferred,” writes Robert W. Wood, Investopedia. “Most swaps are taxable as sales, although if yours meets the requirements of 1031, you’ll either have no tax or limited tax due at the time of the exchange.”

There’s no limit on how frequently you can do a 1031, even if you have profit on each swap.

“You can roll over the gain from one piece of investment real estate to another and another, and another,” says Wood.

This means that your investment continues to grow tax-deferred until you sell for cash. Then, you only pay one tax on a long-term capital gains rate, currently 15 or 20 percent depending on income (zero percent for some lower-income taxpayers).

To qualify, the exchange must be of “like-kind,” but what does that mean? You might actually be surprised. Like-kind does not refer to the type of property, but rather to the nature of the investment, meaning any type of property can be exchanged for another. But you couldn’t, for example, exchange an investment property for a personal residence. Excluded properties generally involve stocks, bonds, notes, securities, interests in partnerships, and property held “primarily for sale.” The Tax Cuts and Jobs Act of 2017 eliminated personal and intangible property from being included in tax-deferred exchanges

“Classically, an exchange involves a simple swap of one property for another between two people,” says Woods. “But the odds of finding someone with the exact property you want who wants the exact property you have are slim.”

Because of this, most exchanges are delayed, three-party, or Starker exchanges. In a delayed exchange, a middleman known as a qualified intermediary controls the money from each transaction. They hold the cash when you sell your property and use it to purchase the replacement property.

The three primary 1031 exchange rules to follow are:

1. Replacement property should be of equal or greater value to the one being sold
2. Replacement property must be identified within 45 days
3. Replacement property must be purchased within 180 days

Have Questions? United Development Realty is Here to Help!

Whether you’re still struggling with that big question – what is 1031 Exchange – or you just need a little extra guidance, partnering with the right broker can make all the difference. United Development Realty is a licensed and experienced commercial real estate broker in Maryland specializing in real estate consulting. We start by listening to you – your current situation, your wants, and your needs. Then, once we fully understand your business, we can help you review your options and, ultimately, help you make the best decision for your business. Our client-first approach to commercial real estate consulting ensures that your unique needs are met.

Please call our office today (locations in Bethesda 240-221-1976 and Fells Point 410-522-1632) to get in touch with a licensed broker.