How Savvy Investors Build Their Portfolios, Defer Tax Burdens Through 1031 Exchanges

One of the most powerful and effective tools in a commercial real estate investor’s toolbox can be a 1031 exchange.

Under Section 1031 of the Internal Revenue Code, a 1031 exchange gives CRE investors the ability to sell their existing commercial property and reinvest their profits in another property of the same or greater value. Many institutional and individual investors make the most of this provision, as it is estimated that yearly transaction volume involved in 1031 exchanges tops $100B. 

To gain the full benefits of 1031 exchanges, investors must abide by strict rules from the IRS — or risk prompting an immediate tax burden. 

If an investor sells commercial property and buys a replacement property of the same or greater value within six months of the sale, they can defer all of the taxes that they would have otherwise paid on the sale. 

“If you time it right and do the exchange, not having to pay significant taxes gives you more purchasing power to buy your next property,” said Steve Wolterman, president and owner at 1031 Federal Exchange and founding attorney at Wolterman Law Office.  

This nuanced process begins with the sale of a property that’s being used for commercial/investment purposes, Wolterman said. From the closing date, the investor has 45 days to select up to three properties that could be a suitable “like-kind” swap. The acquisition of the next property must occur within 180 days, or else the exchange is rendered null. 

In the meantime, while investors may be in a holding pattern between properties, Wolterman said the investors can't touch the money they have earned from the sale. All proceeds must be held in escrow by a qualified intermediary, such as 1031 Federal Exchange, until the next property is purchased. 

The QI is responsible for prepping all legal documents during the transaction, protecting proceeds from the sale as well as ensuring that all documents follow state and local laws. The QI must be a neutral third party, Wolterman said. But beyond that, there is no set of qualifications these intermediaries must meet under federal law. 

Not all QIs are created equal, Wolterman said. That is why selecting an experienced qualified intermediary is a crucial step in the process. The fate of hundreds of thousands — oftentimes millions — of dollars depends on it.

Based in Loveland, Ohio, 1031 Federal Exchange serves as a qualified intermediary on a national scale for these like-kind exchanges. Wolterman Law Office is a full-service law firm specializing in business law, real estate, class-action, probate and tax law. With Wolterman at the helm of these firms, the two collaborate to deliver legal and transactional support for 1031 exchange clients.

“Most QIs are companies that just escrow the funds and provide some documentation, but we all know there’s a lot more to the conversation,” he said. 

Wolterman said it is important for clients to bring on his firms’ QI and legal services as early as possible in the exchange process. That way, they can go above and beyond the typical duties of a QI and provide guidance on more nuanced legal issues that may impact the exchange. Those can include tax implications, how to optimally structure the exchange or even how to go about corporate restructuring to achieve the client’s goal.

“We take the time to walk our clients through these exchanges because they can get very complicated pretty quickly,” Wolterman said. “Given our 15-plus years of experience, we’re able to work through many issues for our clients. We understand the ins and outs of this process, so we can put their tax advisers at ease.”

Bringing in 1031 and legal experts early in the exchange process can also help to avoid one of the biggest mistakes made by investors: thinking they can set up the exchange after a property has already been sold, he said.

“We get phone calls every week from all types of investors across the country who say they’ve recently sold a property and they now want to participate in the exchange after the property has already been sold,” Wolterman said. “That's not the case.”

Beyond the typical “forward” or “delayed” exchanges that are most common under Section 1031 of the Internal Revenue Code, Wolterman said he and his team have worked on a variety of like-kind exchanges, even ones that stray from industry norms, including “reverse” exchanges, “simultaneous” exchanges and “improvement” exchanges.

Wolterman said he recently facilitated a reverse exchange for a client, a transaction where the QI temporarily holds the title of the new property that’s been acquired while the sale of the current property is being completed. 

In this case, Wolterman’s client had a large real estate transaction, but to ensure compliance with state tax credits, they needed to keep the entity in place that was selling, he said. If they had sold the existing property to a new owner before they acquired a new property, they would have been disqualified from tax credits tied to their existing property. 

“This type of exchange is more complex than the ‘forward’ or ‘delayed’ exchanges that we see most frequently,” he said. “We were able to quickly — in less than a week's time — pull together a reverse exchange and park the relinquished property, solving a lot of problems on this big transaction.”

Wolterman said 1031 exchanges will continue to be an important tool for savvy investors looking to grow their portfolios. If investors aren’t quite sure where to start on their 1031 exchange journey, turning to companies like 1031 Federal Exchange and Wolterman Law Office can provide a unique perspective.

“Because of both our legal and QI expertise, we can work seamlessly with all kinds of parties involved in these transactions while still providing that personalized feel of a boutique firm,” Wolterman said. 

This article was produced in collaboration between Studio B and 1031 Federal Exchange. Bisnow news staff was not involved in the production of this content.

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