Tax reform and commercial real estate

Dale Beede
Dale Beede

Despite all the political hoopla surrounding passage of federal tax reforms, little appears to have changed in terms of the effects on commercial real estate.

So-called 1031 like-kind exchanges remain in place for real estate, although exchanges for personal property are gone.  Depreciation, or cost recovery, periods remain the same.  Commercial properties are still based on a 39-year recovery period, while residential properties remain at 27.5 years and leasehold improvements at 15 years.

Of course, changes did occur to tax rates on corporations, and the exemption on estate taxes was raised from $5 million to $10 million. The deductions for state and local taxes are now capped at $10,000, which could mean higher taxes for property owners.

It still makes sense to invest in commercial real estate, and most of the tax advantages of real estate ownership remain in place.

Regarding Internal Revenue Code Section 1031 tax-deferred exchanges, let’s discuss the basics of a tax-deferred exchange.  The 1031, or tax-deferred exchanges, are allowed in most sales of investment real estate to defer taxes owed on the sale of the “relinquished property” by investing, within the time limits allowed, in a different or “replacement” property.

What are the taxes we’re concerned with here? Taxes on capital gains — appreciation on the relinquished property through holding period over the cost of acquisition plus any improvements and the recapture of depreciation (cost recovery) taken by the owner through the time the property was held. The amount of depreciation that is owed at the sale as a tax is 25 percent of the total depreciation taken by the investor. It’s entirely possible the recapture of depreciation taken exceeds the tax for capital gains.  These rates refer to federal taxes only. Ask your accountant about state taxes.

In simple terms, the exchange of your relinquished property for a different property of the same value or greater and with the same debt coverage or greater, could mean you defer capital gains taxes and depreciation recapture until you sell the replacement property. If an investor does this several times over a long period of time, it could mean that instead of money going to pay taxes upon each sale, that same money is invested into a replacement property each time and the resulting investment value grows substantially. This is one of the ways government “partners” with you on real estate investments.

The replacement property must be valued at or above the relinquished property, and new debt must be equal or greater to the debt carried on the relinquished property. Unless these two requirements are met, the exchange won’t defer 100 percent of the taxes. In addition, you may designate up to three replacement properties. But they must be named in writing with the exchange accommodator — the company holding your exchange funds —  within 45 days of the closing date of the relinquished property. It’s imperative you not wait until the last moment to find a replacement property. In fact, it’s usually best to locate prospective replacement properties prior to the sale of the relinquished property. The replacement property must be purchased within 180 days of the sale of the relinquished property.

Keep in mid this is just a broad brush look at 1031 exchange guidelines.  Obtain competent accounting and legal guidance prior to embarking on an exchange.

One Response to "Tax reform and commercial real estate"

  1. Michael Lantrip   January 24, 2018 at 7:52 pm

    Very good article. Good information.
    However, there is one clarification.
    It is not a requirement of Section 1031 that the debt placed on the new property be equal to or greater than the debt that was paid off on the relinquished property.
    The requirements are that all of the Net Sales Proceeds from the sale of the Relinquished Property be used in the purchase of the Replacement Property, and that the Replacement Property be of equal or greater value.
    The difference between the Net Sales Proceeds and the Purchase Price of the Replacement Property can be made up of debt, or it can be cash. Or it can be part cash and part assumption of an existing mortgage.
    But Section 1031 does not force you to take on debt in order to acquire your Replacement Property. As long as you use all of your Net Sales Proceeds, and buy a property priced at least as high as the Sales Price of your Relinquished Property, the IRS doesn’t care where you get the rest of the money.
    I hope this helps.
    Michael Lantrip, Author of “How To Do A Section 1031 Like Kind Exchange.”