Potential Capital Gains on your Commercial Real Estate
Mar. 7, 2019 Article

Potential Capital Gains on your Commercial Real Estate? We Can Help With That.

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One of the most common transaction types in the commercial real estate space, a 1031 exchange can be a great way to defer capital gains from commercial real estate sales by reinvesting proceeds from the sale of one type of business property into another business property.

While there are multiple requirements that must be met to successfully execute these transactions, the tax benefits in doing so can be substantial over time. And, for as great as 1031 exchanges are, there may be even better options to help investors defer capital gains and achieve their goals related to commercial real estate holdings.

Question 1: What is a 1031 exchange, and could it benefit me?

Answer: Section 1031 of the Internal Revenue Code stipulates that when a property being held as an investment, or used for a business purpose, is sold and the proceeds are used to purchase a comparable business property, no gain or loss on the sale has to be recognized for tax purposes as long as certain specific requirements are met.1 Generally, this means an intermediary must be used to facilitate the exchange and that within time frames specified by the code, the second property is identified and the entire sales process is completed.

For real estate professionals, or even individuals who own rental property, farmland, or other types of business real estate, this can be a great tool to acquire increasingly more valuable property, conceivably without having to pay capital gains tax. Where it can be especially helpful is when someone, whether through purchase on their own or some kind of inheritance, owns property that has a low-cost basis relative to the current market value of the property. Rather than sell the property and pay significant taxes, the individual can exchange the property and continue deferring those gains.

Question 2: Are there other tax deferral opportunities similar to a 1031 exchange?

Answer: While the 1031 exchange is more popular, there is also an investment vehicle known as a Delaware Statutory Trust (DST), of which ownership interests can be purchased using cash or 1031 Exchange proceeds.2 The benefit in using 1031 exchange proceeds for a DST is that the investor continues to defer any recognition of capital gains with the potentially added benefit that a DST does
not require active management like an apartment complex or commercial property might. There are some negative aspects of a DST, however. They typically require any cash, or 1031 exchange proceeds contributed to the fund to remain invested for at least five years. Additionally, there may be large up-front fees. So, while there is a potential tax benefit in deferring capital gains, there is also potentially a large cost to do so.

Question 3: Is there an alternative option to avoid capital gains and simultaneously support my favorite charity?

Answer: One of the lesser utilized strategies when it comes to the tax-free exchange of commercial properties really isn’t a 1031 exchange at all. If a real estate investor has highly appreciated property with potentially significant capital gains consequences resulting from its sale, they can also utilize a Charitable Remainder Trust (CRT) to avoid those gains instead of exchanging for another property.3

While transferring the property into the CRT permanently removes it from the control and estate of the investor, the investor can still receive income from the property during their lifetime. At their death, the property is passed on tax free to a previously designated charity. While there are several other nuances and technical requirements in utilizing a CRT, it can be a great way to achieve the dual objectives of avoiding capital gains while also supporting causes that are important to an investor and their family.

 

1https://www.law.cornell.edu/uscode/text/26/1031
2https://www.treasury.gov/press-center/press-releases/Documents/rr0486.pdf
3https://www.forbes.com/sites/ashleaebeling/2013/08/14/charitable-shelter-how-cruts-cut-capital-gains-tax/#1fc028917374

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