Darren Lizzack, MSRE Associate VP NAI James E. Hanson 201 488 5800 x104 This e-mail address is being protected from spambots. You need JavaScript enabled to view it More Info

What is a 1031 Exchange (Like-Kind or Tax Deferred) and Why Should You Care?

There are two fundamental reasons someone would purchase real commercial property. The first reason is because the tax code/law enables the property owner to depreciate the asset over time and thereby creating a tax benefit for the ownership. The general idea is that over time, the bricks and mortar of the building lose economic value because like everything else, wear and tear is caused naturally and in theory, you should not be able to sell the same bricks and mortar for the same price many years later after construction.

The current tax law enables a property owner to depreciate a commercial building (non-residential) over 39 years. When you purchase a property, your accountant will help determine what is depreciable because you cannot simply depreciate the entire purchase price of the property. The main reason is because land is not considered a depreciable asset. Another thing to consider goes beyond the scope of this message and I recommend contacting your accountant or someone who specializes in cost segregation to find out more about the benefits of considering cost segregation. The general concept is that the tax code allows you to accelerate certain items over a much shorter period of time than the 39 years.

A second reason you may consider acquiring real estate as an investment alternative is because of the advantage you receive by reducing the property’s income (on paper) when you place your financing. It is rare for someone to purchase, for example, a commercial property and use all their hard earned cash for the purchase. If you own your property free and clear, speak to a new tax advisor today; the one you have now is not providing you with adequate service. Therefore, it is typical to place financing on the acquired property simultaneously with the closing of the purchase. When you place financing on commercial property, it is similar to what happens with a residential home that you purchase in that each monthly payment you send to the bank, a portion of it goes to repayment for the principal amount borrowed and a portion of the monthly payment goes towards interest. It is the interest payment that is tax deductable.

Now that you have a basic understanding of why someone would purchase real estate, I can explain what a 1031 exchange is. If you were to sell your commercial property, taxes are paid on the realized gain from the sale; in other words, you pay taxes on the difference between what you sold the property for and your adjusted basis remaining in your property. To make a long story short, sometimes the realized gain is an extremely high figure which may deter people from wanting to sell their property. This is of the reasons that the internal revenue code provides for 1031 like-kind exchanges.

The 1031 Tax-Deferred exchange allows you to sell your property and defer paying the government all the taxes owed provided you follow a strict set of guidelines to acquire another like-kind property. If you own a commercial property for investment purposes and you sell that property, you may defer all the taxes if you purchase another property within 180 days. The savvy investor would often acquire a property that exceeds the value of the property sold. The reason for this is two-fold; you may have sold your property after owning it so long that you no longer take advantage of the two reasons I mentioned above which is why investors purchase property in the first place. Therefore, if you acquire a larger asset and you place financing on the new property you acquire, you can begin to take advantage once again of the two benefits of owning real commercial property.

Why is this important today you ask?

It is suffice to say that sales activity has dramatically weakened over the past couple/few years and if you have been reading and listening to what has happened in the financial world, you would think there is a relatively low demand for 1031 exchanges today. I believe that this is going to change over the next 18-24 months for one simple reason; lenders are going to be forced to deal with the problem loans they currently hold. Up until now, they have been putting band aids on the wounds, however, in order for the market to fully recover, they are going to force the sales of property at current market values.

The example of the 1031 exchange I mentioned above is going to take on a new shape as these sales occur. The reason being that if you own a commercial property and you are forced to sell the property for less than what you paid, structuring a 1031 exchange solution may be your best alternative; the reason being once the sale occurs, the original borrower faces substantial tax consequences. And with the current administration in place, the tax figure may be as high as 37%. Below is a simplified example to consider:

You purchased your building for $1 million many years ago (land value was identified as $200,000) and you had the ability to depreciate up to $800,000 over 39 years using straight line depreciation. Remember, the $200,000 land value is not depreciable. Fast forward to today, you have refinanced the building a few times and taken some cash distributions. Today, your property is worth $2 million and you decide to sell. You only depreciated $600,000 of the $800,000. The adjusted basis today is $400,000; you depreciated 75% of the total allocable building cost (the $800,000). Because you had refinanced the property, you still owe $1.5 million to your lender so once you close on the sale of your property and repay the bank; you will have approximately $500,000 of cash remaining.

The reason you would entertain the concept of a 1031 exchange is because your tax advisor will show you that you have a realized gain of $1.6 million on the sale ($2 million minus your adjusted basis). You would be responsible for paying 15% (capital gains tax rate) to Uncle Sam which equates to $150,000. And remember all the depreciation you took over all those years ($600,000), now you have to pay Uncle Sam the recapture tax currently at a rate of 25% or $150,000. And you must not forget that in NJ, you have state taxes as well to consider. Let’s say you are going to be taxed at 8% for this example, you owe the state of NJ an additional $128,000. Out of your total $500,000 cash from the sale, you have paid $428,000 to the government unless you entertain a 1031 exchange successfully.

The above example has been simplified for illustration purposes, but the point of the exercise is to show you how important this could be for you. I can show you how to execute a 1031 exchange and avoid (defer) paying all that money to the government or I could show you how to satisfy your exchange, avoid paying the government (deferring the tax liability) and also put up to 92% of the cash left over back into your pocket.

If you read the above article carefully, my hope is that you are sitting there scratching your head asking yourself more questions. There is no way I could explain everything that is involved with 1031 exchanges in this blog entry but you should have enough information to begin asking me for more help in explaining how this all works.

I hope you found the article to be informative and I welcome you to comment on this blog page if you simply click here to bring you to where the blog is being hosted: http://njcrea.com/brokerage/nai. You may also email directly at This e-mail address is being protected from spambots. You need JavaScript enabled to view it to further discuss. Stay tuned for future articles regarding commercial real estate. You may also explore blog entries from other members of the New Jersey Commercial Real Estate Alliance (www.njcrea.com).

And most importantly, enjoy the rest of your summer since it’s almost gone!

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