There are several reasons why real estate investments can be a great component of your investment portfolio. Some of the benefits include diversification, where real estate can be used as a to diversify your investments beyond the traditional asset classes such as stocks and bonds. Rental properties can provide a steady stream of rental income which can be a great passive income stream. Having control of the tangible asset, you can make improvements to increase the value, increase rent to improve the cashflow, and even strategically sell or exchange to modify the location of the property owned.

One method that can be used when considering a sale of a commercial property is a 1031 exchange. When you think of this transaction the first thing that comes to mind is deferring the gain on the transaction and the related tax effect. One thing that may not be as apparent is that this type of transaction can also allow you to have higher liquidity and consequently acquire a property at a higher price point. Consider the following example:

An investor purchases a property which then is sold, five years later at a gain. The year that the sale takes place, part of the cash proceeds received from the sale would go to the IRS to satisfy the tax consequences. That cash paid to the IRS would not be available for downpayment on the next transaction. If a 1031 exchange is used, much more cash would be available and consequently,  acquiring a property at a higher price point would be possible. With the large increases in property values that we are seeing in areas like Miami, this would be a plus to the investor.

 

When considering a 1031 exchange there are several things to consider such as:

 

1. Identification of Replacement Property: The IRS requires that you identify the potential replacement property or properties within 45 days of selling your original property. You can make a selection of up to three properties.

 

2. Same Taxpayer Rule: The tax code requires that the taxpayer who sells the original property must be the one who buys the replacement property. This applies to individuals and entities.

 

3. Holding Period and Intent: This type of transaction usually isn’t for individuals or entities trying to flip properties. There isn’t a written rule but common practice is for the investor to hold the property for at least one year.

 

Another thing to keep in mind is that you have 180 days after selling your property to close on the replacement property. A Qualified Intermediary should be involved in handling the transaction to ensure all 1031 exchange rules are followed.

As you are preparing to file your taxes, this type of transaction should be disclosed to your tax preparer to ensure that the proper steps are taken timely to not jeopardize the potential tax benefits. Contact us today to get started with your tax planning and to find out how we can support your strategic vision.