Instead of paying taxes on the sale proceeds, these funds can be used to invest in equity. In addition, a tax-deferred swap is an option for commercial real estate sellers who plan to purchase again.

Section 1031 allows real estate held in the United States for investment or use in a taxpayer's trade or business to exchange for a similar property without paying federal income taxes. The same is true for most state tax codes. Although there are some technical requirements and timelines to complete the exchange, it is straightforward with clear-cut rules that have been authorized by law.

All capital gains taxes, all depreciation recapture tax, and all passive investment taxes can be deferred. In most cases, income taxes from the state can also be deferred. However, these taxes can be more than 30%, so it is a good idea to reinvest the funds instead in like-kind properties to continue receiving an investment return.

What Is "Like-Kind Property"?

It is common to misunderstand the concept of "like-kind" property. It is much simpler and more comprehensive than one might think. The U.S. can exchange any real property that is located in the country and used in the taxpayer's trade or business for any other U.S. realty. This includes any property held in the U.S. for investment or use in the taxpayer's trade or business. An example of this is an apartment building that could be traded for a warehouse, farm, retail store, or vacant land used as an investment property.

It is not the physical use of the property that makes it like-kind. Rather, all realty located in the U.S. is similar to all other U.S. realty. Foreign real estate can be similar to U.S. property but not to other foreign properties. The only condition is that the real property being sold must be held for investment or use in the taxpayer's business. The real estate to be acquired must also have been acquired for investment purposes or use in the taxpayer's business.

Are there Time Constraints?

The taxpayer doesn't need to know what property will replace the property being bought at closing. Taxpayers have 45 days to find a potential replacement property and 180 days after closing to purchase the replacement property.

The selling taxpayer must not be able to take physical or constructive possession during the exchange period. The seller will name a qualified intermediary to receive the funds in accordance with an exchange trust agreement. This can often be done quickly and usually within one or two days of closing. The seller/taxpayer cannot access the funds during the exchange. Still, the seller/taxpayer can direct the qualified intermediary so that the funds are used to purchase any replacement property the taxpayer has identified during the 45-day identification period.

To defer all taxes, the entire sale proceeds must be used to purchase the replacement property. This definition includes cash received at closing as well as any mortgage debt that has been paid.

Brokers And Investors Get Benefits

Structured as a tax-deferred sale, there are many benefits and not many drawbacks. Although the rules are complex, they are easy to follow. It has almost no effect on the buyer and offers extraordinary benefits for the seller.

An exchange is a way for brokers to get a lead into the next transaction. They can also broker the purchase or replacement of property equal or greater in value. The transaction must be closed within 180 days.