As a commercial real estate owner, you will eventually sell an investment property. You may receive an offer too good to refuse, or you could be selling after a long, successful holding period. A 1031 exchange is advantageous because it allows you to defer paying taxes on the sale of your investment property for as long as you want.
Before you begin the process of your 1031 exchange, let’s discuss the complexity of the transaction and why deferring taxes is so important.
What is a 1031 exchange?
A 1031 exchange, also referred to as a “like-kind exchange,” allows real estate investors to defer tax liability on the sale of an investment property. It is considered an “exchange” when you use the proceeds of the sale to acquire a new property or multiple properties. You do not actually receive proceeds from the sale of your investment property; therefore, you have no income to tax.
The beauty of the 1031 exchange is in its simplicity. Your taxes can be deferred on any gain indefinitely as long as you receive no monetary benefit from the sale of your investment property. You can sell, then hold, sell again, and hold some more as a method to avoid paying taxes. You are not eliminating taxes; you are deferring them or “kicking the can down the road.”
Deferring Taxes: Why is this important?
When you sell your investment property, you will be faced with paying two kinds of taxes: capital gains and depreciation recapture. Capital gains tax is due when you sell a property for more than you paid for it. Let’s say you purchased an office building for $450,000 and sell the property three years later for $575,000, your capital gain would be $125,000. Because you held the property longer than one year, your long-term capital gains rate would be 20% and you would effectively owe $25,000 in capital gains. In addition, there is a Net Investment Income Tax of 3.8% which would mean an additional $4,750 in taxes owed.
Depreciation recapture is the second type of tax and designed to offset depreciation deductions you claim each year as an investment property owner. For commercial real estate, you can depreciate over a thirty-nine (39) year period. Your $450,000 investment property will generate an annual depreciation deduction of $11,540±. Over time, these deductions add up and your cumulative depreciation is considered taxable income when you sell the property. Stay awake…I am almost done.
Assuming your holding period for the property is three years, total depreciation deductions for this period would be $34,620±. If it is assumed your tax bracket is 32%, you would owe $10,960± in depreciation recapture.
Total Estimated Tax Liability |
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| Capital Gains | $ 25,000 | |
| Depreciation Recapture | $ 10,960 | |
| Net Investment Income Tax | $ 4,750 | |
| TOTAL | $ 40,710 | |
As illustrated above, the sale generated a $125,000 profit but also generated a Total Estimated Tax Liability on your $575,000 sale of $40,710. If you want to pay $41,710 in taxes today, be my guest. If you want to continue the investment cycle and avoid paying taxes indefinitely, choose a 1031 exchange.
You will come to find a 1031 exchange is the best tax advantage available to savvy commercial real estate investors. Don’t shortchange yourself – work with a qualified and experienced commercial real estate advisor who can help guide you to your best investments.
Stirling Investment Advisors specialize in the investment sales of retail, multifamily, office, healthcare and industrial properties. Our extensive experience, developed from intimate knowledge of the Gulf South market, allows us to provide unique, value-added advice and solutions to our clients. Please reach out to us to discuss your real estate investment strategies.
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Justin Langlois, CCIM is a Commercial Real Estate Investment Advisor with Stirling Investment Advisors servicing Baton Rouge, Louisiana, and surrounding markets. Justin can be reached at (225) 329-0287 or jlanglois@stirlingprop.com.
