Many commercial real estate (“CRE”) owners make the mistake of thinking Section 1031
like-kind exchanges will always be the most tax efficient way to realize the gains on their
appreciated property. This reasoning ignores two important considerations:
1) Owners that want to cash out some or all their investment are likely out of luck; and
2) 1031 Exchanges merely defer the taxes – leaving owners with an ever-growing tax bill
when they finally cash out.
1031 Exchanges allow CRE owners to defer capital gains taxes on the sale of an investment
property (the “relinquished property”) if they reinvest the sale proceeds into another similar
investment property (the “replacement property”). One of the requirements for completing
a 1031 Exchange is that 100% of the net proceeds from the relinquished property sale must
be reinvested in the replacement property.
Requiring all net proceeds to be reinvested in the replacement property effectively means
the seller cannot cash out any portion of their investment. Any proceeds not reinvested may
be treated as “boot” and subject to taxation.
Even if a seller wants to walk away from the transaction with a new piece of CRE, a traditional
1031 Exchange avoids taxes upfront, but that tax liability is still waiting for them before they
can enjoy the gains. Eventually, the owner will cash out and pay taxes on the amount that the
purchase price exceeds their “tax basis,” which generally corresponds to their investment.
Because the owner’s tax basis in the relinquished property carries over to the replacement
property, they will pay taxes on all of the deferred gains from prior 1031 Exchanges.
Astute tax planners can introduce CRE to an upgrade to the traditional 1031 Exchange, which
has been met with IRS and U.S. Tax Court approval. Owners may be able refinance their
property and use the loan proceeds without triggering taxes. Careful planning is required as
the IRS is wary when this happens as part of a 1031 Exchange, because additional debt
reduces the amount of net proceeds that need to be reinvested with the seller pocketing the
difference.
Refinancings that are not integrated parts of 1031 Exchanges and have “independent
economic substance” should not cause the exchange to fail to qualify for Section 1031
treatment. In a 1983 case, the U.S. Tax Court allowed a taxpayer to add new debt to his
property prior to a 1031 Exchange without triggering taxable boot, because the new debt had
economic substance independent from the exchange. Garcia vs. Comm., 80 T.C. 491 (1983).
In 2001, the IRS issued a ruling for a taxpayer that received replacement property from a 1031
Exchange and subsequently refinanced it. PLR 200131014. The IRS held that the loan had
independent economic substance, so the loan proceeds were not taxable boot and the 1031
Exchange was unaffected.
As such, when structured carefully and correctly, CRE owners may be able to combine the
tax benefits of a traditional 1031 Exchange with the cash receipts of a taxable sale. If the
seller wants to buy a new piece of CRE, they can (but do not have to) reinvest that cash in a
way that increases their tax basis, which gets them off the “tax deferral treadmill.”
Tax professionals at Wilson Hand are experienced in structuring 1031 Exchanges and
subsequent refinancings, if applicable. We can help ensure your transaction furthers your
short- and long-term financial goals. For questions, please email me at
[email protected].