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1031 Exchanges: Commercial Real Estate Tax Deferral Opportunities

Blog post April 22th, 2024
Maura Snabes
Esquire, Principal, CES®, NTP®, CSS.
Shelly A. Ashmore
CPA, MST and tax partner, DG&N.

Discover why 1031s continue to be an amazing option for your commercial clients.

We spoke with Shelly Ashmore, CPA at Dennis, Gartland & Niergarth, to dive into the world of Section 1031 tax-deferred exchanges. Our chat was a quick refresher on 1031s, as well as the latest changes, advantages and most frequently asked questions. Discover why 1031s continue to be an amazing option for your commercial clients.

What is a 1031 Exchange?

A 1031 exchange is a clever strategy that allows taxpayers to sell real property used for business, trade, or foreign investment and then acquire replacement real property, deferring the payment of capital gains taxes. Timelines play a crucial role in ensuring compliance with 1031 guidelines. First, there’s a 45-day identification period, where the taxpayer must identify potential replacement properties in writing and submit it to the intermediary within 45 days of closing the sale. Subsequently, the taxpayer must complete the acquisition of one or more of the identified replacement properties within 180 days of the sale closing or the tax return due date (including extensions). It’s highly recommended to enlist the services of a qualified intermediary, as this ensures that the taxpayer doesn’t receive any funds during the exchange period, solidifying the legitimacy of the transaction.
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Over our 40-year collaboration, what do you think has been the largest change or changes to Section 1031 of the Internal Revenue Code?
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One significant change we've observed is the ability to perform reverse exchanges. Traditionally, exchanges involved selling the first property and parking the funds with a Qualified Intermediary (QI), then finding a replacement property.

However, now we can also do reverse exchanges, where the replacement property is acquired before finding a buyer for the existing property, which opens the door to effectuate a 1031 exchange for more taxpayers. Another notable change is the option to increase the value of a property and use more exchange funds, through an improvement exchange. If you find a property that falls short of the required value to declare your desired gain, you can have improvements made to the property during the 180-day period. This allows you to acquire a higher value property and achieve your full-deferral. More recently, the Tax Cuts and Jobs Act brought about a change where eligible property for exchanges is now limited to real estate. Personal property exchanges, such as equipment or aircraft, are no longer permitted. The focus is exclusively on real estate exchanges.
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Is a 1031 always going to be beneficial for a commercial property seller?
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In general, as long as your intention is to reinvest in real estate and benefit from the tax deferral, a 1031 exchange is a wonderful opportunity for tax deferral. There may be situations where it might not be advisable. For instance, if you have available losses, such as capital losses, ordinary losses, or net operating losses, that can offset the gain, it may be a reason to reconsider the 1031 exchange. Additionally, if you anticipate increasing capital gain rates in the future, it could be a suitable time to recognize the gain now. However, as a general rule, as long as your intention is to reinvest in real estate, a 1031 exchange is advantageous.
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What are the allowable exchange expenses in a 1031 exchange, what expenses are not allowed, and how are they treated? Do these expenses directly reduce capital gains?
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Most of the closing costs listed on the settlement statement are considered qualified exchange expenses. This includes commissions, title insurance, and qualified intermediary fees. Additionally, tax adviser fees, although not explicitly mentioned on the settlement statement, can also be qualified expenses. On the other hand, financing fees such as loan costs, points, and appraisal fees for the mortgage are not considered qualified exchange expenses. Other items like rent prorations and association dues, while appearing on the settlement statement, are generally reportable in other sections of the tax return. It's important to note that exchange expenses will indeed reduce your gain.
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If a closing statement includes some mortgage expenses, how do you advise your taxpayer to deal with that?
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I may not always have the upfront details to offer specific advice, but it's important to consider alternatives like having enough cash to cover expenses or carefully reviewing the terms of the mortgage. Generally, the crucial aspect to assess is whether the total debt on the new property is lower than the debt on the existing property. If there is a reduction in debt, known as boot, it may result in a taxable gain on a portion of that reduction.
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What do you see as the largest or the greatest advantage of someone doing a 1031 exchange?
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For someone who wants to remain invested in real estate, there is no reason to hesitate. Even if it results in a partial deferral, as you mentioned, the greatest advantage lies in the tax deferral it offers. When calculating the tax rate on the gain, various factors come into play. This includes any past depreciation recapture, which is taxed at a rate of 25%, as well as a 15% to 20% rate on the gain. The net investment income tax can add another 3.8%, and state tax, currently at 4.05% in Michigan, must also be considered. By adding up these rates, the total tax rate on the gain can range from 28% to 33%, depending on the past depreciation taken. Therefore, being able to reinvest that additional one-third of your proceeds is an enormous advantage and opportunity.
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Is there a mandated holding period within the Internal Revenue Code and how long do I need to hold on to property that I acquire in an exchange?
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There's not really a mandated time in the code except if you sell to a related party exchange, then it's two years.
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Is it allowed to do a refinance after I acquire 1031 property and have that money be cash free or tax free?
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Yes, it is allowed to refinance after acquiring a 1031 exchange property and have that money be tax-free. During the 1031 exchange process, you report the debt differences at the time of the exchange itself. After the exchange is closed, the debt on the acquired property can be refinanced, and the money taken out in this refinancing process would not be taxed. This allows you to defer any potential tax gain while having access to cash for other purposes.

Featured Speakers

Maura A. Snabes

SVP, Corporate Counsel,
corporate settlement solutions.

Maura has been the corporate legal counsel for a title company since 1994 and has been with Corporate Settlement Solutions since 2002, as SVP, Corporate Counsel.

She is a Certified Exchange Specialist® as certified by the Federation of Exchange Accommodators and is the founder and co-owner of Corporate Title Exchange Services which was founded in 1995 and which is a qualified intermediary for forward, reverse and build-to-suit tax-deferred exchanges. She regularly gives seminars on 1031 exchanges and other real estate matters to real estate and tax professionals in Northern Michigan.

Maura is highly involved with the community and is a member of the State Bar of Michigan; Charlevoix-Emmet Bar Association; Phi Alpha Delta Law Fraternity; Antrim-Charlevoix-Kalkaska Association of Realtors, is chair of the Professional Designation Board of Review for the Michigan Land Title Association (MLTA) and is a member of the MLTA Legislative Steering Committee. She is also a licensed Michigan real estate broker, Michigan Certified Land Title Professional (CLTP), ALTA National Title Professional (NTP) and is an ICLE contributor.

Maura and her husband live in Charlevoix, Michigan and have three grown children. She enjoys singing, traveling and participating in and watching competitive sports.

Shelly A. Ashmore

CPA, MST and tax partner, Dennis, Gartland & Niergarth.
Shelly A. Ashmore, CPA, MST brings over 30 years in public accounting to her position as tax partner at Dennis, Gartland & Niergarth.

A partner in the tax department, Shelly provides compliance services as well as technical research and planning on a variety of complex tax issues. She serves a broad array of individual and business clients, with significant experience in the oil and gas industries and specialization in mergers, acquisitions and S corporation and partnership taxation.

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