The mega-wealthy of their world – particularly the self-made millionaires and billionaires – have made their fortunes in many ways, but there is a common thread among many of them.
They have made commercial real estate a central part of their investment strategy. Of all the ways the self-made ultra-rich have made their fortunes, real estate outpaced every other method 3 to 1.
Not only do the ultra-rich know how to build empires through real estate but they also use all the tricks and strategies at their disposal to pad their wealth including taking advantage of the tax code and favorable tax laws to minimize their tax liabilities. Fewer taxes means a bigger investment base for compounding wealth.
One of the wealthy’s favorite tools for deferring taxes is the 1031 exchange.
The 1031 exchange, rooted in Section 1031 of the Internal Revenue Code, allows investors – both individuals and entities – to defer capital gains taxes from the sale of one investment property or asset and using those proceeds to acquire another property or asset of equal or greater value.
This exchange must occur within a specified period of time.
Besides timing, the two most important criteria for qualifying for 1031 exchange tax deferral are:
- The properties included in the transaction must be like-kind; and
- The exchanged properties must be held for “productive purposes in business or trade” (an investment).
Although qualifying business assets used in a productive business such as large farm or manufacturing equipment can qualify for 1031 exchange treatment, the vast majority of transactions involve commercial real estate.
A common misconception about 1031 like-kind exchanges is that investors can only exchange one property for another similar type of property – for example, a multifamily property can only be exchanged for another multifamily property.
Fortunately, the tax code does not specifically define a like-kind of property and does not limit “like-kind” property to certain types of real estate.
The main criteria for establishing like-kind property is that both properties in the exchange must be held for productive use in a trade or business.
By that definition, the IRS has been pretty liberal in determining what qualifies as like-kind property – more interested in the nature or character of the property, rather than its grade or quality.
Typically, exchanging one productive commercial real property asset for another producing commercial real property asset would qualify for 1031 exchange treatment.
Exchanging a commercial asset for a primary residence would not qualify under this criteria since the primary residence would not be considered a productive business asset. Likewise, exchanging a commercial asset for a REIT interest or partnership interest in a real estate investment fund would also not qualify for 1031 exchange treatment.
The following non-comprehensive list of assets are examples of like-kind property:
- Unimproved Property
- Improved Property
- Vacant Land
- Net-Lease Property
- Commercial Buildings
- Rental Properties
- Farms or Ranches
- Resort Property
- Industrial Property
- Retail Property
- Office Buildings
- Self-Storage Facilities
- Senior-Living Centers
- Hotels or Motels
- Restaurants
- Daycare Facilities
- Tire and Automotive Stores
- TIC Properties
The following would qualify for 1031 exchange treatment:
- Raw land for farmland.
- Oil & gas interests for a ranch.
- Fee simple interest in real estate for a TIC (Tenancy-in-Common) interest).
- Commercial, industrial, or retail rental properties for any other commercial real estate.
- Rental beach condos for a multi-family building.
Besides the like-kind requirement, timing is also crucial in qualifying for 1031 treatment.
From a timing perspective, there are two types of exchanges: simultaneous and deferred:
- A simultaneous exchange involves either two parties “swapping” properties with each other, or the exchange closing on both the sale of the relinquished property and the acquisition of the replacement property on the same day.
- By far the most common form of exchange, a deferred exchange is an exchange in which the investor has 180 days to finalize the exchange after it takes place.
For example, if an investor sells an apartment building they have 45 days to identify a replacement property and the purchase of the like-kind property must be completed within 180 days of the sale of the apartment building.
In big, related news, on April 9, 2020, the Treasury Department issued Notice 2020-23, which addressed the threat posed by the COVID-19 crisis to 1031 exchange timing issues by extending the 45-day and 180-day deadlines beyond their scheduled deadlines to July 15, 2020.
In a deferred exchange, the investor must use a qualified intermediary. A qualified intermediary is an agent who facilitates the 1031 exchange process, by holding net proceeds from the relinquished property before they are reinvested in the replacement property.
The 1031 exchange is a big deal and a valuable tool used by the wealthy to defer taxes in perpetuity – especially on property owned through an entity that makes transferring interests upon death or other life events more convenient.
Although property owned by an individual cannot be exchanged for a partnership interest in a real estate investment fund, nothing stops that fund from taking advantage of 1031 exchanges at the entity level and deferring taxes at the entity-level for the benefit of its investors indefinitely.
The mega-wealthy love commercial real estate and they love any favorable tax laws that reduce their tax liabilities and put more money in their pockets for building wealth.
And one of their favorite tax strategies is the 1031 exchange, which they take advantage of liberally through both direct investments and indirect investments in private real estate funds that take advantage of 1031 exchanges to defer tax liabilities for the benefit of their investors.