'Powerful Tool For Investors': Setting The Record Straight On IRC Section 1031
Internal Revenue Code Section 1031, a federal statute for deferring capital gains tax, is used in as many as 20% of commercial real estate transactions. Despite this, misunderstandings about this tax-deferral strategy often prevent CRE investors from benefiting from its provisions.
According to Chicago Deferred Exchange Company, those fallacies can range from a misconception that IRC Section 1031 is a tax shelter for the wealthy to confusion over how the average CRE investor can use it effectively.
CDEC is a qualified intermediary and exchange accommodation titleholder that has helped investors defer gains from property transactions since 1989. It has facilitated more than 60,000 transactions for individuals, corporations, REITs and others across the country, with a special focus on helping them to comply with and benefit from IRC Section 1031.
This century-old section of the federal tax code allows a seller in a CRE transaction to delay, but not avoid, paying taxes on a gain if the proceeds are reinvested in a similar property as part of a qualifying like-kind exchange.
“It is a powerful tool for investors that allows them to keep more of their money in their businesses,” CDEC CEO Mary Cunningham said. “If you're selling an operating business without doing a 1031 exchange, you may be paying up to 40% of your proceeds in taxes.”
One thing that IRC Section 1031 is not, she said, is a tax loophole for wealthy individuals or corporations. In fact in most transactions, the investor ultimately sells their replacement property in a taxable transaction.
“It is a pro-business provision, but it is not a loophole or a tax shelter,” Cunningham said. “Studies have shown that it is a really good economic stimulator.”
A 2020 study concluded that like-kind exchanges such as Section 1031 are critical to maintaining a healthy and liquid real estate market.
“Taxpayers engaged in like-kind exchanges invest more capital into their replacement properties than non-tax-motivated purchasers, and take on less debt,” the study’s authors concluded. “These lower loan-to-value ratios decrease risk in our financial system.”
PLAN AHEAD
Section 1031 can benefit CRE investors who are getting back in the game after sitting out the tough market of the past few years, Cunningham said.
“It’s a great impetus for people who have been holding their powder dry or didn't want to sell something because they couldn't get the financing or rate they wanted,” she said. “They might now be more encouraged to do so in 2025.”
It is here, though, where another misconception can arise, in this case concerning how much time an investor has to take advantage of the full benefits of a like-kind exchange.
IRC Section 1031 gives a taxpayer 45 calendar days from the date of sale to formally identify a replacement property and 180 calendar days to close on the replacement property from the date they closed on their relinquished property. These critical dates can confuse a less experienced investor who might miss their opportunity to defer their capital gains tax.
“The biggest thing that we talk to people about is to plan ahead, because you don't have an unlimited amount of time to find your replacement property and to execute on the purchase, especially when there is a lack of inventory available,” CDEC Executive Vice President Chris Newton said.
Newton urged investors to give themselves as much time as possible to do a like-kind transaction and explore their options for a replacement property. While 180 days might seem like a long time, it might not be a wide enough window for some purchasers to arrange financing.
“If you get to the closing table and say, ‘You know what, I'm going to do a 1031 exchange,’ you need to realize that the clock starts ticking on that day,” he said. “You've got a very limited amount of time to figure out what you might want to buy, which tends to be a bigger challenge than actually completing an acquisition.”
Newton said another misconception for some investors concerns the amount they need to invest to avail themselves of a tax deferral.
“It's not just spending your gain, it's buying property equal to or greater than the gross value of the property that you sold,” he said. “If you're selling property for $100M but your gain is only $50M, then you need to buy a replacement property that's $100M or more in value to defer all of your tax.”
A LOT OF HAND-HOLDING
Going it alone on an IRC Section 1031 can be difficult for most CRE investors, which is why they seek the help of a qualified intermediary like CDEC to keep them on top of the law’s nuances and instill trust that their proceeds are being held in a secure manner during the exchange.
“You want bench strength and stability in your QI — an entity that's been doing this for a while and seen a lot of things and brings a lot of expertise to the table,” Newton said. “The fact that CDEC is owned by Wintrust Financial Corporation means we're under the same regulatory scrutiny the bank is, which means our operations are very transparent compared to what some mom-and-pop operations may be.”
An investor is likely to require frequent communication with their QI during the exchange, so they need to be confident the intermediary is reliable and always reachable to field their questions.
“We want to be consultative and part of their team,” Cunningham said. “We're working on a $100M transaction for an investor that is their first exchange, and there’s been a lot of calls about how to deal with deposits and the documentation required. The process involves a lot of hand-holding, but that's what we like to do.”
For more information about IRC Section 1031, call 312.373.1484 or email chris.newton@cdec1031.com.
This article was produced in collaboration between Studio B and Chicago Deferred Exchange Company. Bisnow news staff was not involved in the production of this content.
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