Defer Taxes on the Sales of Your Self Storage Investment with a 1031 Exchange
When you decide that it’s time to sell your self storage facility or any other commercial real estate investment, can you take your profit, avoid capital gains taxes and escape to a Tuscan villa? Actually, you can make this happen by using an IRS provision called a 1031 exchange. Theoretically, you could sell your facility or commercial real estate investment, purchase a new asset (maybe a winery) in Italy, and live out your Tuscan dreams.
What is a 1031 Exchange?
According to Investopedia, “Section 1031 is a provision of the Internal Revenue Code (IRC) that allows a business or the owners of investment property to defer federal taxes on some exchanges of real estate.” Qualifying Section 1031 exchanges are also known as like-kind exchanges or Starker exchanges. This provision is used by investors to eliminate capital gains taxes by reinvesting in a “like-kind” property. To clarify, a like-kind property simply means that the property involved in the exchange must be for business or investment purposes.
Understanding the Rules for a 1031 Exchange
Investopedia states, “Section 1031 defers tax on swaps of like-kind real estate done in a timely manner. There are a number of important steps to a properly structured 1031 exchange:” It’s important to adhere to the following rules and structure when participating in a 1031 exchange.
The real estate purchased with the proceeds must be like-kind. This means both properties involved in the exchange must be for business or investment purposes. Personal residences do not qualify as like-kind properties. A few examples of like-kind properties are:
- Another Self Storage facility
- Multi-Family Buildings
- Strip Malls and Shopping Malls
- Outdoor Hospitality and RV Parks
- Mineral Rights
The tax must be paid on any “boot” in the year of the 1031 exchange. A boot is an addition of value to the property that is not real estate. For example, if you sell a property for $200,000 but only re-invest $150,000, the $50,000 difference is known as the boot. You would pay taxes only on the $50,000 profits.
Once the business or investment real estate is sold, like-kind real estate must be identified within 45 days and acquired within 180 days. For instance, after selling a self storage facility, at least one reasonable property must be identified within 45 days of the sale. This does not have to be the one that is purchased, but you have to keep the timeline moving forward. You then have 180 days to purchase a like-kind property to legally 1031 exchange self storage to eliminate capital gains taxes.
What is a Reverse Exchange?
A reverse exchange allows a property owner to purchase the new asset before the old property is sold. Section 1031 does not indicate that “reverse exchanges” are prohibited, but the property owner is not permitted to own title to the new acquisition until the old property is sold. In this case, however, there is a path around this minor drawback.
One solution is to have an unrelated third party, or “accommodation party,” purchase the new property. An associate of the taxpayer can lease from the accommodation party and have full use of the new property, including the right to add improvements.
The accommodation party can also borrow funds from a financial institution for development and renovation. This loan can be non-recourse to the accommodation party but guaranteed by the principal equity owners of the taxpayer. This is critical because Treasury Regulations require that the new investment must be of the same amount or more than the old one, or tax must be paid on the profits. These profits are sometimes referred to as the “boot” (see above).
Reporting a 1031 Exchange
Even though the tax is deferred, the 1031 exchange must be reported on Form 8824, Like-Kind Exchanges. The gain recognized from the boot is reported on Form 8949, Schedule D (Form 1040), or Form 4797. A 1031 exchange is complex and mistakes can result in significant expense. It is to your advantage to work with professionals who have established track records in this area and can ensure that tax code requirements are met.
If you have additional questions about how to report your 1031 exchange on your taxes we recommend that you speak with a CPA experienced in real estate tax filing.
A 1031 exchange is an excellent way for savvy owners and operators like Pinnacle Storage Properties to build tax-deferred wealth. This article, however, serves only to provide an overview of a 1031 exchange and how it functions. Like any complex process, mistakes can be costly. That is why it is our recommendation to consult a reliable tax advisor with experience in navigating the complex regulations connected with this type of tax deferment.