Commercial real estate owners and investors are always looking for new ways to generate profit in their investments. To leverage opportunities and reap the rewards of past investments, it’s sometimes necessary to sell existing property. While generating profit is essential in the sale of commercial real estate, it’s equally important to be aware of tax issues which can arise from such transitions. To minimize capital gains tax liabilities, there are many tax planning strategies which can be used. One common tool which defers tax liability is known as a 1031 Like-Kind Exchange. While a 1031 exchange can offer compelling savings, it is not right for every situation. To help clients, prospects and others understand the pros and cons of a 1031 exchange, KROST CPAs has provided a brief summary of each situation below.
Pros of 1031 Exchanges
Deferral of Taxes – Clearly this is the top benefit and reason why so many property owners leverage this tax saving tool. In any transaction, taxpayers are generally concerned with capital gains taxes they will owe on resulting income. For most, the maximum federal tax rate on capital gains is 15%, but for those taxpayers in the highest bracket it can be as much as 20%. A 1031 exchange allows the property owner to defer taxes resulting from the gain on the sale into the future.
Enhanced Cash Flow – By deferring the taxes due on a transaction, the seller will have access to significantly more immediate cash, which can be invested into a new parcel of real estate. The additional money may even allow the taxpayer to invest in a higher value property or series of other properties using the money that would have otherwise been used to pay taxes.
Fewer Management Responsibilities – Occasionally, a company or individual taxpayer elects to sell a property because of the many management responsibilities. These can include maintaining the structure itself, HVAC repairs or replacement, as well as making aesthetic updates and keeping the structure in good working order to attract tenants and maintain compliance with local and other regulations. As properties age this often becomes a key concern for ownership. Using a 1031 exchange allows property owners to get out of one property and purchase another that has less management needs – without incurring the high tax liabilities.
1031 Exchange Drawbacks
Exchange Structure and Complexity – Unlike a traditional real estate sale, 1031 exchanges are subject to a complex set of rules which include meeting timing and other requirements. The IRS mandates that the seller cannot directly receive funds from the transaction, which calls for a qualified intermediary to be involved. The role of the intermediary is to receive the funds from the transaction and acquire the replacement property. Take into consideration that costs are associated with the intermediary and their services.
Tax Deferred, Not Tax Free – It’s important to understand that a 1031 exchange does not mean that tax liabilities disappear. It simply means that the tax liability is deferred until a later date. When the property is sold in the future, the resulting taxes will be assessed at the time of the transaction.
A 1031 exchange offers a compelling tax savings benefit for real estate owners. However, the strict regulations of these transactions means it is not ideal for every taxpayer. If you have questions about 1031 exchanges or would like assistance with tax planning, KROST can help.
Please contact us if we can be of assistance with this or other tax planning matters.