Have a Commercial Real Estate Property? New Tax Laws on Your Side for Use of 1031 Real Property Exchanges

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By Rana M. Gorzeck

The commercial real estate market breathed a sigh of relief when President Trump’s new tax bill, Public Law 115-97, preserved the use of 1031 transactions for commercial real estate properties.

Let’s review what a 1031 Like-Kind Exchange is defined by the IRS:

Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale.  IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.  Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.

With the domestic commercial real estate market thriving, income-producing real properties are being exchanged again with increasing popularity.  Congress did not allow the continuation of 1031 exchanges for personal property, such as vehicles, jewels, and stocks, but the capital gains tax will continue to be deferred when parties exchange like properties—as long as the strict 1031 rules are met.

As a result, in this increasingly active real estate market, we are witnessing a revival of 1031 exchange transactions at our firm.

Recently, we were presented with a typical “problem”’ when it comes to 1031 transactions.  Our client in South Florida held a parcel of land with a small office building.  He had used this location as his professional office for 40 years.  Upon retirement, he was delighted to discover that his land had increased in value by more than 10 times his original purchase price!

However, the problem was the large capital gains tax he would have to pay once he sold this desirable property.

Section 1031 of the Internal Revenue Code permitted this professional to defer the large capital gain taxes due and exchange the office building, his “relinquished property,” for two other properties which were “like kind assets”—that is, they were also commercial real estate properties that were income-producing.  By doing this, he was able to purchase two new “triple net” properties, a drug store and a bank.  The favorable long-term leases for both of his new properties provided a perfect stream of income for his retirement.

1031 exchanges can be used for any size of investment properties. This includes small income-producing properties (such as a rental home) and large income-producing properties (such as an apartment complex or office building).

It even includes “triple net investments,” which are properties occupied by a tenant (often blue chip) with a business—such as a drugstore, restaurant, or bank—which pays for all the operating costs of maintaining the property.  For example, the tenant covers fees such as the taxes, insurance, and maintenance costs, in addition to the monthly rent.  The new property or properties to be acquired are the “replacement properties.”

The key is to follow the rules carefully, with an experienced attorney to guide you through the process.  You will also need to choose an independent 1031 intermediary, who will act as the escrow agent to hold the sales proceeds at and after the closing of the relinquished property. This applies until you purchase your replacement property or properties.

Since it is important that the initial sales contract contain language agreed upon by the parties—that a 1031 exchange is anticipated, plus setting the requirements to allow the 1031 exchange to occur—it is critical to hire an attorney to assist you.  An attorney will be able to guide you before you begin negotiation and preparation of the Purchase and Sale Agreement (which is known as the PSA).

Throughout Ward Damon’s 30-year history, our team of real estate attorneys has closed many commercial real estate transactions for our clients. Should you have a need to defer capital gains tax on the exchange of your income-producing commercial property, we would be happy to consult you on your proposed 1031 transaction.

Rana M. Gorzeck is a partner at Ward Damon, with more than 34 years of experience, who assists owners of real properties and businesses, and lenders throughout Florida, with their transactional and insurance defense needs.  If you have questions regarding your real estate and property matters including 1031 exchange transactions, please contact Rana at rgorzeck@warddamon.com or call (561)842-3000.

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