Real Estate Articles

1031 Exchanges

Written by Brent Pace for Gaebler Ventures

If you are looking to expand your real estate holdings you should be aware of the options afforded you under USC 1031 which allows for a tax-free exchange of properties under certain circumstances.

When expanding your real estate portfolio, you will often find that the property you want is often not for sale.

1031 Exchanges

Sometimes it is a corporation that is simply unwilling to move. In other instances, you may want to purchase some ground that is currently held by a Mom and Pop type operation that is simply comfortable where they are it. Either way, one tool you can use to encourage these folks to deal with you is a deal structure called the 1031 Exchange.

What is a 1031 Exchange?

A 1031 exchange is made possible through USC 1031. Basically, this law allows for real property to be purchased and exchanged in such a way that the participants can defer recognition of capital gains or losses. This can be huge for individuals who wouldn't mind moving their operation to a better facility, but don't want to pay the taxes to do it. Since this authority is made available through the Internal Revenue Code, you will want to retain good legal counsel and probably a CPA before attempting to negotiate this kind of transaction.

Rules and Qualifications for a 1031 Exchange

There are a few important qualifying factors in order to do a 1031 exchange. One is that the properties have to be used for productive business purposes. In other words, you can't do this on residential real estate. Commercial real estate is the largest user of 1031 exchanges. The first step in a 1031 Exchange is to identify some like-kind property for the exchange.

The 1031 Exchange has many rules, but there are three major rules: 1) the three property rule states that you may identify up to three replacement properties, regardless of their value; 2) the 200% rule states that if the three property rule is exceeded that the total fair market value of the replacement properties cannot exceed 200% of the purchased property; and finally 3) the 95% rule states that you can identify as many replacement properties as you'd like with as much value as you'd like as long as you close on 95% of the value you have identified as like-kind.

An Example

Let's say you have a large manufacturing facility that sits next door to an old apartment building. As a growing business, you would love to expand but need to buy the apartment building to do so. The owner of the apartment building is old, and just enjoys the cash flow off the building. He doesn't want to sell. You suggest to him that you enter into a 1031 Exchange to help him get the most out of the deal.

To execute the deal you would go out and identify an alternate apartment building and purchase it. This new property (or properties) would have to meet the three rules listed above. Then, upon execution you take the new property you purchased elsewhere and exchange it for the apartment property next to you.

When executed properly, everyone benefits. The old apartment owner gets another property without paying capital gains on the transaction. In the meantime, you have acquired the property you need to expand your plant. As always, it is wise to retain good legal counsel, and in this case a CPA or tax accountant, prior to entering into this kind of transaction.

Brent Pace is currently an MBA candidate at University of California at Berkeley. Originally from Salt Lake City, Brent's experience is in commercial real estate development and management. Brent will have tips for small business owners as they negotiate their real estate needs.

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