Leveraged Breakdowns

1031 Exchanges: Managing Tax Liability for Optimal Private Equity Real Estate Returns

One of the great things to come out of the 80’s (as opposed to legwarmers and headbands) was the 1031 exchange. Like-kind tax deferred exchanges have been allowed since the 1920’s or so, but the concept wasn’t permitted in its current form until a series of court decisions and tax law changes in the 1980’s. Those changes unleashed a flood of real estate equity investment, the result of higher after-tax private equity real estate returns.

What is a 1031 exchange?

A 1031 exchange is a “like-kind” exchange of assets that permits you to defer the tax liability associated with the sale. “Like-kind” exchange is just what it sounds like- exchanging similar types of assets: building and land for building and land. The IRS used to allow this type of tax strategy for both real property and intangible property, but changes in 2017 now limit these transactions only to real property (real estate). And, it must be either real estate used in the ordinary course of business or held for investment (property held for sale does not qualify).

The point of using a 1031 exchange is to defer tax liability associated with the sale of a property. The rule allows an owner to sell one property, buy another similar property, and not pay any tax on the gain from the sale. The tax liability is deferred until a future sale when a 1031 exchange is not utilized.

An Example, Please?

Suppose your fund has owned an office building that it leases to multiple tenants for several years, and receives an unsolicited offer of $20,000,000. Your firm bought the building 5 years ago for $15,000,000. The book value of the property is $13,076,923 (deduct 5 years of depreciation on the purchase price). The taxable gain on the sale would be $6,923,077.

Without 1031 exchanges, your firm would have to report $6,923,077 as a gain and pay tax on that amount. With a 1031 exchange however, your firm can acquire a similar property in exchange for the sold property, and transfer the tax basis to the new property, deferring the tax until some time in the future.

In our example, if your firm acquired a $25,000,000 distribution facility (the like-kind doesn’t have to be the same type of real estate asset, just another real estate asset) in accordance with the exchange rules, the tax basis in the new property would be $18,076,923 (purchase price of $25,000,000 less gain on prior sale of $6,923,077). Your tax depreciation schedule for the new building would then be based on your beginning basis of $18,076,923, whereas your book depreciation schedule would be based on a purchase price of $25,000,000.

Basic Rules for a 1031 Exchange

There are just a handful of basic requirements that you need to know. There are actually a myriad of rules that CPAs and tax lawyers can utilize, but for a beginner, there are just a few to remember:

  • You must identify the replacement property within 45 days of sale of the relinquished property
  • You may identify up to three potential replacement properties
  • You must acquire the replacement property within 180 days of the sale
  • To avoid any potential tax liability you must acquire a property that is of equal or greater value than the sold property (if the replacement property is less, there will be taxable gain, or “boot” equal to the difference)

The Big Boost to Real Estate Equity Investment

You can see through the example why 1031 exchanges are such a boon to the industry. In this example, a 20% federal tax rate would result in taxes of almost $1.4 million ($6.9 million gain on sale multiplied by 20%)! Instead, all of the gain can be used to acquire a replacement property and generate additional private equity real estate returns.

Test Your Comprehension

Work through the following example to practice this concept. Post your answer on our Forum!

  • Selling an apartment complex for $125,000,000
  • Purchased 8 years ago for $110,000,000
  • Acquiring another apartment complex for $140,000,000
  • What will be the tax basis in the new apartment complex at closing?
  • At a 20% Federal tax rate, how much tax has been deferred?

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