Capital gains are one of the most gratifying features of investing in the commercial real estate sector. Well, that’s before the government swoops in for their cut, which can be anywhere up to 40% of the gain. Failing to remit such taxes can get you into deep legal trouble and cost you a lot of money.
Unless of course, you do it legally, which is where 1031 tax exchanges come in to save the day.
Just how do you legally stiff the IRS?
Technically, you don’t get to go scot-free, but instead, you get to defer any capital gains made when selling commercial property. Section 1031 of the tax code mandate the IRS to let investors in the commercial real estate sector defer capital gains. Naturally, that comes with a few strings attached.
A significant requirement is that you re-invest the entire sales amount back into the commercial real estate sector. The main reason behind this provision is the need to cope with growing housing demand. The government recognizes housing needs of an increasing population can far outstrip the supply.
As a result, the government resolved to help investors grow their ability to acquire commercial buildings. Such a move proves to be a masterstroke as deferring capital gains increases investor confidence as well as their financial foundation.
How do you go about a property exchange process?
Surprisingly, property swap isn’t subject to the usual government bureaucracy, making the process quite appealing. The entire process revolves around trading one commercial property for another, often larger and grander one. The replacement property can be in the same real estate market vertical or a different one.
Replacement properties can be in the same neighborhood or in an entirely different state, which is a godsend in the lucrative sector. It’s as if you can uproot a property from one location and supplant it in a choice location without all the construction hassle. Best of all, you can do all this without setting foot in a government office.
The process decrees that you hire an expert, known as qualified intermediary, to handle the matter. These experts will help you with just about every aspect of the matter from identifying the replacement process to striking a deal with the owners.
But why hire a qualified intermediary?
Although the entire process is called a property exchange, it’s merely a matter of selling one property and using the proceeds to buy a replacement property. However, there’s one small twist. You not only need to reinvest the entire sales amount into the sector, but the money shouldn’t pass through your accounts.
If that happens, you will be nullified from the process. That’s why you need to outsource the entire process to a qualified intermediary. The sales proceeds are deposited into their bank accounts before it’s paid out to the sellers of the replacement properties.
Using an intermediary also lowers your chances of taking boot, which will subject you to capital gains taxes.
The government is quite ruthless in its pursuit for capital gains taxes. In most cases, that works to almost 40% of your profit. Taking part in a property exchange lets you hang on to all your gains without attracting the wrath of the IRS.