Commercial and other real estate owners are often seeking new ways to maximize value and increase profits.
See also Real Estate Accounting
To take advantage of new opportunities or reap the rewards of existing investments it’s sometimes necessary to sell existing real estate. While generating profit from a transaction is essential to success, it’s important to be aware of the tax issues which can arise. Many in the industry are already familiar with 1031 exchanges, which offer the opportunity to defer tax liabilities. Although the strategy offers compelling savings it may not be right for every situation. To help clients, prospects and others understand the benefits and drawbacks of a 1031 exchange; Hanson & Co has provided a brief summary below.
1031 Exchange Benefits
Deferral of Taxes – This is clearly the top benefit and reason why so many property owners leverage this tax saving tool. Taxpayers are generally concerned with the capital gains tax on real estate transactions. For most, the maximum federal tax rate on capital gains is 15%, but for those taxpayers in the highest bracket it can be 20%. A 1031 exchange allows the property owner to defer taxes resulting from the gain on the sale into the future.
Enhanced Cash Flow – By deferring the taxes due on a transaction, the seller will have access to significantly more immediate cash, which can be invested into another parcel of real estate. The additional money may even allow the taxpayer to invest in a higher value property or series of other properties using the money that would have otherwise been used to pay taxes.
Fewer Management Responsibilities – Occasionally, a company or individual taxpayer elects to sell a property because of the many management responsibilities. These can include maintaining the structure itself, HVAC repairs or replacement, making aesthetic updates and keeping it in good working order to attract tenants and maintain compliance with local and other regulations. As properties age this often becomes a key concern for ownership. Through a 1031 exchange, property owners can get out from one property and purchase another that has less management needs – without incurring the high tax liabilities.
1031 Exchange Drawbacks
Exchange Structure and Complexity – Unlike a straight real estate sale, a 1031 exchange involves much more complexity, including meeting timing and other regulations. The IRS requires that the seller not directly receive the funds from the transaction, which calls for a qualified intermediary to be involved. The role of the intermediary is to receive the funds from the transaction and acquire the replacement property. Beyond this complexity, there are costs associated with the intermediary and their services.
Tax Deferred, Not Tax Free – It’s important to understand that a 1031 exchange does not mean that tax liabilities disappear. It simply means that the liability is deferred until a future point of time. When the property is sold in the future, the resulting taxes will be assessed at the time of the transaction.
Proactive tax planning is essential to realizing the highest gain possible. A 1031 exchange offers this opportunity but has some limitations that should be considered prior to implementing the strategy. If you have questions about 1031 exchanges or would like assistance with tax planning issues, Hanson & Co is here to help. For additional information please call us at (303) 388-1010, or click here to contact us. We look forward to speaking with you soon!