Originally published in American City Business Journals
By Ben Smith
Many real estate owners seeking to realize their gains in the years after the Great Recession are fortunate a vital section of the U.S. tax code remained in place following Washington’s latest reworking of tax laws.
Investors are still able to defer the tax gains from the sale of real estate used in a business or held for investment and reinvest the proceeds into another commercial property through a provision of the tax code know as a 1031 like-kind exchange. Personal property, however — such as equipment, airplanes, art, collectibles and intangibles — no longer qualifies under the new tax law.
Thankfully for property investors, federal tax law preserved the provision for real estate used in a business or as investment, which some in the industry had feared was at risk as lawmakers horse-traded over final details.
The 1031 exchange process has been important for commercial real estate investors to maximize the size of their portfolios after the 2008 property crash by leveraging capital improvements, increased occupancy and higher rents — which have all grown building values.
By deferring the tax on these gains, investors can deploy more capital into opportunities existing in today’s real estate market, such as the demand for logistics and warehouse buildings created by a booming e-commerce sector or entering a secondary geographic market poised for growth as demand for real estate in many primary business districts can limit returns.
Before embarking on a 1031 exchange, investors should work with a professional tax adviser to assess the exact tax liability on their property to determine the value of the replacement property required to defer the capital gains tax. Investors should then check if they have passive losses elsewhere in their portfolio that could offset those gains, allowing them to cash out without a significant tax implication. If a meaningful tax liability remains, a 1031 exchange can be an effective way of deferring tax and should only be handled by a professional real estate adviser and CPA who have handled exchanges due to the many rules and guidelines involved.
Investors utilizing the 1031 structure have only 45 days to identify potential replacement properties and must close within 180 days — tight deadlines in a hot market like this. The transaction must also go through an independent, qualified intermediary who handles funds from sale through exchange.
Due to the quick turnaround needed for a 1031 exchange, investors should have a strategy in place far in advance. Investors should first assess their current risk appetite before considering their next venture, as well as their desire to be a passive or active investor.
Some investors are willing to roll up their sleeves and develop a property, with all the work that entails. Others simply want to buy a building occupied by a single tenant, where the landlord only has to collect rent and is responsible for little to no maintenance or operating expenses. Investors in an office building that has a low occupancy could expect a higher return on investment if improvements are made to the property that attracts new long-term tenants.
If approached correctly, a 1031 exchange can make capital available for these tenant improvements. For example, an investor who sold a building for $5 million, could purchase another building for $4 million and make $1 million in improvements within the 180-day time period.
If an investor cannot find a suitable replacement opportunity, there are other options. Investors can buy into a Delaware Statutory Trust, securing a pro rata beneficial interest in the trust. Similar to real estate investment trusts, DSTs own a portfolio of investment properties that produce a steady stream of income and still qualifies as a mechanism to defer capital gains tax through the 1031 exchange structure.
Deferring the tax liability on commercial real estate dispositions allows investors to maximize reinvestment and thus grow real estate portfolios through their lifetime. With the new tax reform leaving this important mechanism in place, investors can continue to defer capital gains until the property is passed on to heirs who will then receive a step-up in basis to fair market value.
Ben Smith is a partner in Plante Moran’s Real Estate Investment Advisors practice. He brings an analytical perspective to real estate investing with extensive experience in project feasibility, capital markets, portfolio planning, tax credits and development. His clients range from Fortune 100 companies to regional and local entities.