What Is a 1031 Exchange? A Guide for Commercial Real Estate Investors

A 1031 exchange, also called a like-kind exchange, is a tax-deferral strategy that may allow an owner of qualifying investment or business real estate to sell one property and acquire another qualifying real property while deferring recognition of some or all of the gain that would otherwise be recognized from the sale.

The name comes from Section 1031 of the Internal Revenue Code.

A 1031 exchange does not simply eliminate the tax. When properly structured, it generally defers recognition of the gain by carrying the tax basis into the replacement property.

For commercial real estate investors, a 1031 exchange can be an important consideration when selling an investment property and reinvesting the proceeds into another commercial or investment property.

How Does a 1031 Exchange Work?

In a typical deferred 1031 exchange, an investor sells a qualifying investment or business property and acquires another qualifying real property while following specific IRS requirements and deadlines.

The process generally looks like this:

1. Sell the relinquished property. The investor sells the real estate currently owned. This property is commonly called the relinquished property.
2. Use a qualified intermediary. In a typical deferred exchange, a qualified intermediary is engaged to facilitate the exchange. The investor generally cannot simply receive the sale proceeds and later decide to use the money for a 1031 exchange.
3. Identify potential replacement property. The investor generally has 45 days from the transfer of the relinquished property to identify the replacement property in accordance with IRS requirements.
4. Purchase the replacement property. The replacement property generally must be received by the earlier of 180 days after transferring the relinquished property or the due date, including extensions, of the tax return for the year in which the transfer occurred.
5. Report the exchange. A qualifying like-kind exchange is generally reported to the IRS using Form 8824, Like-Kind Exchanges.

Because the deadlines are strict, investors considering a 1031 exchange should discuss the transaction with their tax professional and qualified intermediary before the original property closes.

What Is a Like-Kind Property?

The phrase “like-kind” does not mean that an investor must sell one type of commercial property and purchase exactly the same type.

For Section 1031 purposes, real properties generally can be like-kind even when they differ in grade, quality or use.

For example, depending on the circumstances and other requirements, an investor may potentially exchange:

• A multifamily investment property for a shopping center
• A retail property for an office building
• A commercial building for commercial land held for investment
• A warehouse for a multifamily property
• A strip center for another income-producing property
• Improved real estate for unimproved investment land

The important issue is generally whether both properties constitute qualifying real property and are held for investment or productive use in a trade or business.

U.S. real property, however, is not considered like-kind to real property located outside the United States.

What Properties Qualify for a 1031 Exchange?

Section 1031 currently applies to qualifying real property held for investment or productive use in a trade or business.

Potential examples can include:

• Multifamily investment properties
• Apartment buildings
• Shopping centers
• Strip centers and strip malls
• Retail investment properties
• Office buildings
• Industrial and warehouse properties
• Certain mixed-use properties
• Commercial land held for investment
• Rental properties
• Other qualifying commercial and investment real estate

Eligibility depends on the facts of the transaction and how the property is held.

Real property held primarily for sale generally does not qualify. A taxpayer's primary residence also generally does not qualify simply because it is real estate.

Can I Use a 1031 Exchange for Commercial Real Estate?

Yes. A 1031 exchange can potentially be used when selling qualifying commercial real estate held for investment or productive use in a trade or business and acquiring other qualifying real property.

This can make Section 1031 particularly relevant to commercial property owners who want to sell one investment and reposition their capital into another real estate asset.

For example, an investor selling a small apartment building may want to acquire a shopping center, or an owner selling a retail investment property may want to acquire an industrial building.

The replacement property does not necessarily need to be the same commercial property type as the property sold.

What Is the 45-Day Rule in a 1031 Exchange?

The 45-day rule is one of the most important deadlines in a deferred 1031 exchange.

Generally, the taxpayer must identify the replacement property within 45 days after transferring the relinquished property.

The identification must comply with applicable IRS requirements, including being made in writing and clearly identifying the replacement property.

The 45-day period begins when the relinquished property is transferred—not when the investor begins searching for another property.

That makes preparation extremely important.

Ideally, an investor should begin evaluating potential replacement properties before closing the sale of the relinquished property rather than waiting until the 45-day clock has already started.

What Is the 180-Day Rule?

Identifying a replacement property does not complete the exchange.

The investor generally must receive the replacement property by the earlier of:

• 180 days after transferring the relinquished property, or
• The due date, including extensions, of the taxpayer's return for the tax year in which the relinquished property was transferred.

Because the identification and acquisition deadlines are separate, investors should plan for enough time to negotiate the purchase, perform due diligence, arrange financing and satisfy closing requirements.

What Is a Qualified Intermediary in a 1031 Exchange?

A qualified intermediary, often abbreviated as QI, is an independent party used to facilitate many deferred 1031 exchanges.

The qualified intermediary enters into an exchange agreement and facilitates the transfer of the relinquished and replacement properties in accordance with the exchange structure.

One of the critical considerations is preventing the taxpayer from having actual or constructive receipt of the sale proceeds in a manner that could disqualify the exchange.

For that reason, an investor considering a 1031 exchange should generally have the exchange structure and qualified intermediary arranged before closing the property being sold.

A commercial real estate broker, attorney or accountant who has acted as the taxpayer's agent within the applicable two-year period may be considered a disqualified person for purposes of serving as the qualified intermediary. The QI should therefore be independently selected and properly qualified.

Does a 1031 Exchange Eliminate Capital Gains Tax?

A 1031 exchange generally defers qualifying gain rather than permanently eliminating the tax simply because an exchange occurred.

When a qualifying exchange is completed, the basis of the relinquished property generally carries into the replacement property, subject to applicable adjustments.

This is why the transaction is commonly described as a tax-deferred exchange.

The ultimate tax consequences depend on the taxpayer, basis, depreciation, debt, property values, consideration received and future disposition of the replacement property.

Investors should have their CPA or tax advisor calculate the potential tax consequences rather than assuming that completing a 1031 exchange automatically makes the entire transaction tax-free.

Do I Have to Reinvest All of the Money?

An investor can potentially complete an exchange while receiving cash or other non-like-kind property, but doing so may result in recognition of some gain.

Cash or other non-like-kind property received in the exchange is commonly referred to as boot.

The calculation can become more complicated when mortgages, liabilities, closing expenses and other consideration are involved.

Investors seeking maximum tax deferral should discuss the required reinvestment and debt structure with a qualified tax professional before deciding how much to invest in the replacement property.

Can I Buy a Cheaper Property in a 1031 Exchange?

Potentially, yes—but purchasing a replacement property with a lower value or receiving cash from the transaction may result in some taxable gain.

A 1031 exchange does not necessarily become completely invalid simply because the investor receives money or other non-like-kind consideration. Instead, gain may be recognized to the extent required under the applicable tax rules.

Because value, equity and debt can all affect the tax calculation, investors should have their tax professional analyze the proposed replacement property before closing.

Can I 1031 Exchange an Apartment Building Into a Shopping Center?

Potentially, yes.

The IRS definition of like-kind real estate is considerably broader than many investors assume. Qualifying real property does not have to be exchanged for an identical property type.

For example, qualifying investment real estate may potentially be exchanged between asset classes such as multifamily, retail, office, industrial or land.

This flexibility can make a 1031 exchange useful for investors who want to reposition a commercial real estate portfolio rather than simply replace one property with an identical asset.

Why Commercial Property Investors Use 1031 Exchanges

A 1031 exchange may allow an investor to defer recognition of qualifying gain while reinvesting capital into another property.

Depending on the investor's objectives, the replacement property might be selected to pursue:

• Higher income potential
• A different commercial property type
• A different geographic market
• Greater appreciation potential
• A larger investment
• Portfolio diversification
• Consolidation of multiple investments
• Different management requirements
• A property better aligned with long-term investment objectives

However, the investment decision should not be based solely on tax considerations.

The replacement property should still make sense as a real estate investment.

Selling Commercial Property as Part of a 1031 Exchange

The first real estate component of many 1031 exchanges is the sale of the existing investment property.

Before listing the property, an owner should understand its potential market value, existing income, net operating income (NOI), lease structure, tenant profile, market conditions and likely buyer pool.

A commercial real estate broker can assist with the real estate side of this process by evaluating the market, positioning the property for sale, marketing it to potential buyers and negotiating the transaction.

The owner's CPA, tax attorney and qualified intermediary should separately advise on the tax and exchange structure.

For commercial property owners in Miami and South Florida, Lais Same of Floridian First Realty provides commercial property sales and listing representation for owners considering the disposition of commercial and investment real estate.

Finding a Replacement Property for a 1031 Exchange

Finding the replacement property can be one of the most challenging parts of a 1031 exchange because the investor is working within a defined timeline.

Before selling the relinquished property, it can be helpful to establish:

• Target property type
• Investment budget
• Preferred locations
• Minimum income or return objectives
• Financing requirements
• Desired cap rate
• Property condition
• Tenant and lease preferences
• Management requirements
• Potential replacement properties already on the market

A commercial real estate broker can then search for potential properties that fit those investment criteria.

For investors searching for replacement commercial properties in Miami and South Florida, buyer representation can include identifying opportunities, analyzing market information, coordinating property tours, negotiating offers and assisting with the real estate transaction through closing.

Tax eligibility and the 1031 exchange itself should remain coordinated with the investor's CPA, attorney and qualified intermediary.

What Happens During Due Diligence on the Replacement Property?

The 1031 exchange deadline should not cause an investor to overlook normal commercial real estate due diligence.

Depending on the property, due diligence may include:

• Review of leases and rent rolls
• Income and operating expenses
• Net operating income
• Physical inspections
• Roof, HVAC, electrical and plumbing systems
• Environmental investigation
• Survey and title
• Zoning and permitted use
• Property taxes
• Insurance
• Existing contracts
• Tenant estoppels
• Financing
• Deferred maintenance
• Development or redevelopment potential

The replacement property should make sense independently as an investment—not merely because the investor needs to meet a 1031 deadline.

Common 1031 Exchange Mistakes

One of the biggest mistakes is waiting until after the sale closes to begin planning the exchange.

Other potential problems include missing the 45-day identification deadline, missing the 180-day acquisition deadline, receiving or controlling sale proceeds improperly, selecting property that does not qualify, misunderstanding the like-kind requirement, failing to coordinate financing early enough, and choosing a replacement property primarily because the deadline is approaching.

Investors should coordinate their commercial real estate broker, qualified intermediary, CPA, attorney and lender early in the process.

Each professional performs a different role.

1031 Exchanges in Miami and South Florida Commercial Real Estate

A 1031 exchange can be particularly relevant when an investor is selling commercial property in Miami or South Florida and intends to continue investing in real estate.

The replacement property does not necessarily have to be located in Miami or even Florida. Qualifying U.S. real property can potentially be exchanged for other qualifying U.S. real property, subject to Section 1031 requirements.

From the real estate perspective, the process involves two important decisions:

• How should the existing commercial property be positioned and sold?
• What replacement property best fits the investor's objectives?

These decisions can involve property valuation, market conditions, NOI, cap rates, tenant quality, lease terms, location, financing and long-term investment strategy.

A commercial real estate broker can assist with those real estate decisions, while the investor's qualified tax and legal professionals determine how the transaction should be structured for Section 1031 purposes.

Frequently Asked Questions About 1031 Exchanges

What is a 1031 exchange?

A 1031 exchange is a transaction under Section 1031 of the Internal Revenue Code that may allow an owner to defer recognition of gain when qualifying real property held for investment or business use is exchanged for other qualifying like-kind real property.

How long do I have to find a property in a 1031 exchange?

In a typical deferred exchange, replacement property generally must be identified within 45 days after the relinquished property is transferred. The replacement property generally must then be received within 180 days after the transfer or by the applicable tax-return due date, including extensions, if earlier.

Does the replacement property have to be the same type?

No. “Like-kind” generally does not mean identical property types. Qualifying commercial and investment real estate can potentially be exchanged across different real estate asset classes, provided the properties satisfy Section 1031 requirements.

Can I exchange a multifamily property for a shopping center?

Potentially, yes. Qualifying investment real estate can generally be like-kind even when the properties have different uses or characteristics. The specific transaction should be reviewed by the investor's tax professional and qualified intermediary.

Can I use a 1031 exchange for commercial property?

Yes. Commercial real estate held for qualifying investment or business purposes can potentially be part of a Section 1031 exchange when the other requirements are satisfied.

Can I use a 1031 exchange for my primary residence?

A primary residence held for personal use generally does not qualify as investment or business property under Section 1031. Different tax rules may apply to the sale of a principal residence.

Can I receive the money from the sale and then start a 1031 exchange?

This can jeopardize the exchange. In a typical deferred exchange, the transaction is structured through a qualified intermediary so the taxpayer does not have actual or constructive receipt of the proceeds. The exchange should be planned before the relinquished property closes.

Does a 1031 exchange eliminate capital gains taxes?

A 1031 exchange generally defers recognition of qualifying gain rather than automatically eliminating the tax. The tax basis generally carries into the replacement property, subject to applicable adjustments.

Can I purchase a less expensive replacement property?

Yes, but receiving cash or other non-like-kind consideration can cause some gain to be recognized. The tax consequences should be calculated by a qualified tax professional before the replacement property closes.

Do I need a qualified intermediary for a 1031 exchange?

Qualified intermediaries are commonly used to structure deferred 1031 exchanges and prevent the taxpayer from receiving or controlling the sale proceeds in a manner that could disqualify the exchange. The QI should be selected before closing the relinquished property.

Do I need a commercial real estate broker for a 1031 exchange?

A commercial real estate broker does not structure the tax exchange, but can represent an investor in selling the relinquished property and/or finding and acquiring replacement commercial real estate. The qualified intermediary, CPA and attorney handle their respective exchange, tax and legal responsibilities.

Planning a Commercial Real Estate 1031 Exchange

A successful 1031 exchange requires more than finding another property within 180 days.

The investor must coordinate the sale of the existing property, 45-day identification period, replacement-property search, financing, due diligence and acquisition timeline while complying with applicable tax requirements.

For that reason, planning should ideally begin before the commercial property being sold reaches closing.

Investors considering selling commercial property or searching for replacement commercial real estate in Miami and South Florida can work with Lais Same, Commercial Real Estate Broker with Floridian First Realty, on the real estate components of the transaction, including property sales, investment property searches, market analysis, negotiations and acquisition coordination.

The tax structure and eligibility of a 1031 exchange should be reviewed separately with a qualified intermediary, CPA and/or tax attorney.

Lais Same | Commercial Real Estate Broker | Floridian First Realty

Commercial property sales, investment property searches, buyer representation, market analysis, negotiations and acquisition coordination throughout Miami and South Florida.

Disclaimer: This article is provided for general educational and commercial real estate information only and is not tax, legal, accounting, financial or investment advice. Section 1031 eligibility and tax consequences depend on the taxpayer and specific transaction. Lais Same and Floridian First Realty do not provide tax or legal advice or act as qualified intermediaries. Consult a qualified intermediary, CPA, tax attorney and other appropriate professionals before structuring or completing a 1031 exchange.