Commercial real estate is a complex field for investment, but one that yields strong, successful returns when carefully navigated with the help of experts such as the brokers of Latitude Commercial. Their guidance can also help investors take advantage of other unique opportunities in commercial real estate investment, including one of the most powerful tax-management tools available - 1031 exchanges.
In the simplest terms, a 1031 exchange is the process of swapping one real estate investment property for another in a way that allows the investor to defer the capital gains taxes on the sale. It is named after Section 1031 of the Internal Revenue Code (IRC) and allows an investment to grow tax-deferred. There are many rules and hurdles to work through in the process, but when executed properly, 1031 exchanges are a tax break investors can use indefinitely.
“You trade one property for another and avoid paying any capital gains or recapture taxes for it,” Aaron McDermott, co-founder and president of Latitude Commercial, said. “There are a lot of parameters; you really need to have an expert on hand to make sure it’s done right.”
The single most important hurdle to overcome in a 1031 is that the investor is at no point allowed to hold the money generated from the sale of the original investment property. Instead, it immediately goes to a middleman, known as a qualified intermediary, and starts two timers, one 45-day and one 180-day.
During that 45-day, the investor must identify and designate up to three replacement properties in writing to their intermediary. Only those designated properties qualify for the 1031 exchange, and one of them must be closed on within the 180-day timer – with the intermediary making the purchase for the investor.
“If any of those steps are missed, like purchasing a property that wasn’t on your list, that property you sold is subject to capital gains taxes,” McDermott said. “You also aren’t allowed to accept boot, which is cash or some other property added to make up the value if you decide to buy a property worth less than your original one. If you do, that boot will be subject to capital gains.”
The other major restriction is that the properties being exchanged must be “like-kind,” a tricky term that might make an investor believe, for example, that you must exchange a retail outlet for another retail outlet. There are some pitfalls, but the term is much broader than it first appears.
“Like-kind is really just investment for investment,” McDermott said. “You can’t use this on a house, or even a second house that you want to live-in part time without renting out. Like-kind means that, as long as the property is held for investment or business purposes, it meets the criteria. You can go from owning a two-unit retail building to a five-unit office property.”
The rewards for navigating those restrictions successfully are often massive, and McDermott has seen first-hand how much his clients have saved. Some use it to acquire rental properties that can be used as part-time vacation homes that they rent out for most of the year.
“Let’s say you bought a property 30 years ago for $100,000 dollars that’s now worth $2 million,” McDermott said. “That’s $1.9 million of gains that could be subject to taxes, and depending on factors like your income, those taxes could be close to half a million dollars. Instead of having to pay that, you could purchase a vacation home in, say, Lake Tahoe that you use for three months out of year and rent out for the rest – that’s perfectly legal.”
Since 1031s can be performed continuously, savvy investors also use them to grow their portfolio. Investors can turn to Latitude’s team for help identifying a like-kind property that might soar in value.
“There’s a lot of pressure to find the right site; we’re not just pulling properties off a listing service and saying, ‘Here’re your options,’” McDermott said. “We do our due diligence. We check-in on what the tenants are like, what kind of sales they’re doing, if the tenant is even going to make it. We really focus on if the asset is worth it, like how you compare a Chiptole to an AutoZone investment.”
McDermott and his team have 27 years of experience navigating the market with a broad network of connections that put them in position to meet the demands of a 1031 exchange.
“We, along with their accountants and qualified intermediary, are making sure that we’re finding the types of properties that our clients want to invest in,” McDermott said. “We can search across the entire country for these assets. We’re very experienced in underwriting assets and letting our clients know what might be a good deal and what’s not a good deal. That’s where we shine.”
There are plenty of other intricacies to 1031 exchanges, including tremendous value as an estate planning tool. Latitude is equipped to help its clients find properties that fit their needs, whatever their goals are.
“Whenever I’m looking at properties for a client, I treat it as if it were my own investment,” McDermott said. “I think, ‘would this be a property that I’d buy, and what would I be looking for from it?’ Looking at it from that lens is a huge advantage because I’m pretty conservative in some of what I buy. If you talk to my investors, I’ve been very successful in the assets that we’ve purchased.”
To learn more about Latitude Commercial and its services, visit latitudeco.com.
