1031 Exchange Guide: Tax-Deferred Real Estate Strategy

Unlocking Tax Deferral Through Direct Real Estate Investment

At Trinity Real Estate, we specialize in direct real estate investment strategies that build and preserve long-term wealth. Direct ownership of commercial real estate assets not only offers a well-established means to accumulate wealth, but it can also provide investors with the unique ability to defer taxes that would otherwise be due on gains from a property’s sale.

The process of deferring taxes on a sold, directly owned commercial property is done by “exchanging” the sold property for a newly acquired property. However, the newly acquired property needs to meet the standards defined in Section 1031 of the IRS regulations. The 1031 Exchange can provide material tax benefits, resulting in significantly enhanced future income and value. In effect, if you sell a property and use the proceeds to purchase a like-kind property of the same or greater value through a 1031 Exchange, no taxes on the gain(s) are due or payable from the sale. Real Estate is unique in its ability to defer capital gains taxes, and the 1031 Exchange is a powerful tool that is especially valuable for family offices, high-net-worth individuals, and non-tax-exempt institutional investors seeking to optimize investment returns.

What Is a 1031 Exchange?

Under Section 1031 of the Internal Revenue Code, investors can defer capital gains taxes by exchanging one investment property for another of equal or greater value. This “like-kind exchange” must meet specific IRS criteria; however, when executed correctly, it can result in significant tax savings. There are several types of exchanges, the most common of which are the “Delayed” and “Reverse” exchanges, outlined below. The others are a “Simultaneous” exchange (sell/acquire on the same date) and a “Construction” exchange (can use sales proceeds to complete a project on acquired property). It is important to consult with your tax advisor when implementing a 1031 Exchange to understand all the related rules associated with this process.

Key Benefit: If structured properly, no capital gains taxes are due at the time of sale, allowing the full proceeds to be reinvested for greater compounding potential.

Key 1031 Exchange Rules to Know

It is crucial to have a thorough understanding of all the rules associated with implementing a 1031 exchange. Missing any one of these can put the transaction at risk of becoming a taxable event. Several key 1031 exchange rules are outlined below.

Here are several critical rules:

1. Timing

A successful tax-deferred real estate strategy hinges on strict adherence to the IRS’s 1031 exchange timeline:

• The 45-Day Identification Rule: Upon sale of your existing property, you have 45 days to identify potential properties to acquire and complete the exchange. This is done by submitting a list of properties to your Qualified Intermediary (QI), within the 45 Day Identification period.
• The 180-Day Completion Rule: The acquisition of the identified replacement property must be completed within 180 days of the closing of the sold property.

Pro-Tip: Consider negotiating seller closing extensions in the initial purchase and sale agreement to create more flexibility in this tight timeframe.

2. Property Identification Rules

The IRS places limitations on the number and/or value of properties that can be identified; one of the following identification rules must be chosen.

• Three Property Rule: You can identify up to three properties regardless of their expected cumulative purchase price, OR
• 200% Rule: You can identify as many properties as you wish; however, the sum-total of the new property’s expected purchase price cannot exceed 200% of the sales price of the exchanged properties, OR
• 5% Exception: You can identify any number of properties, but must close on 95% of the value identified.

3. Requirements for Replacement Property

There are several restrictions that the newly acquired properties require to qualify as an appropriate 1031 exchange.

The properties must:

• Be on the identified list.
• It will be purchased by the same entity that sold the original property.
• Be of equal or greater value (including debt) than the property sold at the time of sale.

4. Qualified Intermediary (QI) Required

To qualify for a 1031 exchange, all sales proceeds of the exchanged property need to be placed with a Qualified Intermediary (QI), also called an Exchange Facilitator, who will hold your proceeds until you are ready to put them into escrow for your acquired property. As the seller, you cannot receive the sales proceeds of the sold property until you have exchanged it for another property. Qualified Intermediaries must meet specific IRS requirements. However, these facilitators are not subject to any regulations regarding the custody of funds; therefore, care should be taken in their selection and account controls.

5. Use of Exchange Funds

The IRS does not have defined rules regarding the use of exchange funds to cover certain expenses (such as exchange fees, title insurance, attorneys, appraisals, etc).  Your tax advisor can provide guidance on avoiding inadvertently creating taxable income.

6. Reverse Exchange Option

If you acquire new property and subsequently sell one or more different ones, it may qualify as a “Reverse Exchange”. The same rules apply, noted above, however, in reverse.

Key rules include:

• Once you buy a new property, you have 45 days to identify the relinquished property and 180 days to complete the sale.
• The new purchase price must equal or exceed the sales price of the sold property.
• You need to use an “Exchange Accommodator Title Holder” to hold the acquired property until the exchange is completed.
• The new equity must equal or exceed the amount of equity in the exchanged (or sold) property.
• The same identification rules still apply, but in reverse.

1031 Exchange Process Recommended Considerations

Given the potential for significant tax benefits and the importance of making sure you are selling for the right reasons, an extensive analysis is recommended before embarking on the process of completing a 1031 Exchange.

This analysis includes, among other items:

1. Taxable Gain Estimate

Determine the amount of tax they would owe if the property were sold. If the tax is not material, we will often advise our clients to reinvest outside the exchange process. This helps avoid the pressure of investing within the tight timeframe of a 1031 Exchange. In a competitive environment, 1031 Buyers facing their exchange deadline often become aggressive, sometimes offering terms they wouldn’t normally agree to to avoid paying the capital gains tax.

2. Hold vs. Sell Analysis

Before committing to selling a property, complete a Hold-Sell analysis to make sure the property is being sold for the right reasons. Our recommended “hold-sell” analysis encompasses some of the following questions:

• What are the long-term prospects for the property and the property’s neighborhood?
• Is the property still meeting risk/reward objectives for the asset and for the portfolio?
• Does the property require more improvement/maintenance capital than what you want or could do?
• Is it possible to improve property operations through strategic capital investments and/or management overhaul?
• Is the market currently willing to pay you more than you would pay for the property if it were for sale today?

Pro Tip: Once a sale decision is made, we strongly recommend that clients list their property for sale to gain maximum exposure. We advise them to go through a qualified investment sales broker to ensure a competitive process and to obtain the best combination of price and terms.

3. Strategic Investment Assessment

We recommend conducting a strategic assessment of your goals to help us understand the risk and return profile of a potential replacement property. Some of the questions for completing this assessment are as follows:

• How much risk are you willing to take? Different real estate investments have varying risk profiles, and understanding your tolerance is a key component in identifying a suitable replacement property.
• How important is cash flow? For some families, cash flow is a very important piece of the equation, while for others, it is secondary to asset preservation and long-term returns.
• How much debt are you willing to take on? We recommend maintaining a modest amount of real estate debt to effectively magnify returns. Similarly, we do not recommend high levels of debt that could become a problem during a market downturn.
• Where are your other property types/locations? Asset diversification is important, so when considering a replacement property, thought should be given not only to the property type but also to its geographic location.

4. Replacement Property Identification

By asking the above questions and assessing strategic risk and reward objectives, we collaborate with clients to identify the profile of the replacement property or portfolio. Trinity views potential properties based on their risk-return profiles: Core, Core-Plus, Value-Add, and Opportunistic.

Pro Tip: For clients not actively seeking new opportunities, we recommend enlisting a dedicated professional advisor (like Trinity) who can leverage their owner and broker networks to source opportunities tailored to their needs. This is critical to ensure the identified property is acquired at a fair price, taking into account the asset’s condition, location, and the submarket’s strength.

5. Essential Underwriting & Due Diligence

Upon identifying the replacement property, we recommend completing a thorough underwriting of the prospective property before submitting a purchase bid. This underwriting includes estimates of market rent, operating expenses, capital improvements, and an assessment of any debt required for property acquisition. We also recommend completing a 10-year discounted cash flow analysis to estimate your projected returns on the acquired property. Finally, once a property is under contract, we recommend a thorough improvements due diligence assessment of the property, which includes, among other items, the following studies/reports:

• Environmental Assessment: A “Phase I” Environmental Site Assessment, which a licensed environmental engineer can obtain.
• Property Condition Report: A report that identifies any deferred maintenance or needed expenditures typically within a 10-year period. We recommend finding an advisor with a good reputation and experience in the property type you are acquiring.
• Survey: A survey will identify and ensure against any encroachments or unwanted easements.
• Zoning Report: This report confirms that the property complies with current zoning codes and identifies any potentially significant issues.
• Insurance Review: Utilize a reputable insurance broker to secure proper insurance coverage that protects you post-closing.

6. Proactive Timeline Planning for a Seamless Exchange

We collaborate with our clients to create a timeline for the exchange process well before embarking on the effort. This helps alleviate some of the pressure associated with investing within the tight timeframe of a 1031 Exchange. This often translates to beginning the search for a replacement property well in advance of the anticipated closing date.

Recommended 1031 Exchange Team

Given the complex nature of a 1031 exchange, we recommend that clients considering this process have a qualified team. This team should include the following components:

• CPA/Accounting Firm: The accounting firm will confirm/assist with calculating the depreciated basis and potential tax liabilities of the property being sold, and provide advice/confirmation on meeting IRS guidelines
• Real Estate Attorney: Will assist with all the necessary real estate legal transactional documentation and will be an additional voice in 1031 legal nuances.
• Real Estate Broker: The broker firm(s) can assist with selling as well as sourcing new properties.
• Real Estate Advisor: A full-service real estate advisory, such as Trinity, will be able to assist with coordinating all aspects of a 1031 exchange, including the Hold-Sell analysis, oversight of the property sale and acquisition, creation/confirmation of a portfolio strategy as well as execution of the process of underwriting and conducting due diligence on acquisition candidates.

Trinity’s 1031 Exchange Services

Trinity takes a holistic approach to the 1031 exchange process, starting with an understanding of an owner’s goals and objectives to assess whether a sale is advisable. We then recommend steps to maximize sales proceeds and identify the right broker to sell the property. On the buy side, Trinity sources assets across all product types to match a property profile with a client’s strategic objectives. We utilize our contacts with owners and brokers to identify suitable assets. We then take the lead in conducting due diligence, negotiating appropriate debt structures, assessing risk and opportunity for the asset, analyzing and recommending pricing, overseeing purchase/sale legal documents, and closing the transaction. Along the way, we manage any necessary consultants required during the process.

Furthermore, our structure and experience at Trinity allow us to offer our clients the following asset management service to optimize performance post-closing on any acquisition:

• Establish and implement the asset’s operational strategy
• Report and monitor financial results
• Monitor and manage the property manager
• Oversee necessary capital improvements
• Negotiate leases
• Ensure and monitor proper asset insurance
• Financing oversight

Real-World Case Studies

We have advised numerous clients on successfully completing new property acquisitions through the 1031 process.  While the benefits of the 1031 program are clear, we offer two examples of 1031 exchanges with both positive and negative results.

Successful Exchange: Portfolio Diversification

A family office engaged us to review their established portfolio, which included a large single-tenant building. We completed a Hold-Sell Analysis on the building and recommended a sale based on potential market pricing. Additionally, selling the building would enable the client to diversify their portfolio better. We hired an investment sales team that widely marketed the asset. As part of the sale, we negotiated a six-month closing extension to allow our client time to find a suitable replacement asset in a competitive marketplace. As a result, we were able to sell the asset above its target price and acquire two multi-tenant properties that better fit the client’s investment parameters, significantly improving its diversification and meeting all the 1031 exchange requirements. Trinity handled all aspects of both the disposition and acquisition, including asset identification, underwriting, negotiating purchase contracts, sourcing debt and coordinating closing.

Time-Pressured Outcome

During the review of a new client’s direct real estate portfolio, we discovered that the family had previously acquired two of their properties under the duress of a 1031 exchange. In both cases, the family lacked representation by a seasoned advisor like Trinity, had not developed a strategic plan, and was pressured into purchasing the assets to avoid the taxes that would otherwise be due. The properties purchased were at odds with their risk tolerance, acquired at pricing well above market, and have been significantly underperforming.

Pro Tip: We strongly recommend creating a 1031 strategic investment plan before completing a sale, which will help you avoid poor real estate investment decisions and taxes.

1031 Exchanges Offer Tax Efficiency—If Done Right

1031 exchanges are an effective and beneficial way to defer capital gains taxes when selling directly owned commercial real estate assets. The process can be challenging, but with solid advance planning and an effective team to manage the exchange transaction, it can result in a replacement property that meets the 1031 exchange rules as well as the long-term investment objectives for the investor.

Key Takeaways for 1031 Exchanges

• A 1031 exchange allows investors to defer capital gains taxes by reinvesting sale proceeds into a like-kind property.
• Strict deadlines apply; you have 45 days to identify a new property and 180 days to close the acquisition from the date the relinquished property is sold.
• A Qualified Intermediary (QI) is required to hold the exchange funds.
• Thorough planning, including a Hold vs. Sell analysis and a strategic investment plan, is crucial to avoid suboptimal investment decisions.

About the Authors

Richard Leider, Managing Partner

Over the past 30 years, Richard has provided real estate advisory, development, and investment services to family office and institutional projects valued at more than $2 billion. His product experience includes office, residential, retail, hotel, mixed-use, and industrial properties, totaling over 3.6 million square feet. As an industry expert, Richard has been featured in The New York Times. He has served as a contributing source for the annual Urban Land Institute/PricewaterhouseCoopers publication, Emerging Trends in Real Estate. He served on the board of directors of the Pacific Real Estate Institute and is both a past president and former national board director for the National Association of Industrial and Office Properties.

Pete Stone, Managing Partner

Pete Stone joined Trinity Real Estate in 2010 after 12 years at ING Clarion Partners, where he closed over $2 billion in real estate investments. His expertise in investment, development, asset management, and consulting has consistently helped complex and often challenging projects deliver improved returns for owners. Pete’s experience encompasses all kinds of commercial and multifamily properties, including hospitality, office, multifamily, industrial, and retail. Whether approaching a distressed portfolio or competing for a coveted redevelopment challenge, Pete is skilled at matching opportunities with client goals while aligning the needs of investors with each project’s complex web of stakeholders. An active member of the Urban Land Institute, Pete is an advisory board member for the Pacific Northwest chapter, as well as an active member of both the Pacific Real Estate Institute and the National Association of Industrial and Office Properties.

About Trinity Real Estate

Founded in 2001, Trinity Real Estate provides full-service, personalized real estate services and investment solutions to family offices and institutional investors nationwide. Trinity’s hands-on, high-touch, and full-service approach has led to the acquisition, management, development, and repositioning of more than $3 billion in assets. These assets span all sectors of the real estate market, including office, industrial, multifamily, hospitality, and mixed-use. TRE’s objective is to create, enhance, and preserve real estate assets that produce strong long-term returns for its clients.