One of the most unique aspects of owning self-storage real estate is the ability to defer capital gains taxes through the use of Section 1031 of the Internal Revenue Code. Using a 1031 exchange, you can use proceeds from the sale of one property to invest in another property without immediately paying a capital gains tax. Essentially, you are changing the form of your investment–using the sale of one property to buy another property or properties–without cashing out.
As long as you swap for a new, qualifying property, you are basically receiving an interest-free loan from the federal government in the amount that you would have paid in taxes on gains from your relinquished property. All of the funds received from your relinquished property must go towards the purchase of the replacement property.
In order to qualify for a 1031 exchange, you must meet the following requirements:
Properties must be ‘like-kind’ and used for a ‘productive purpose in business’
If you are selling a self-storage facility and using the proceeds from the sale to purchase other facilities, you certainly qualify for a 1031 exchange. Surprisingly, this ‘like-kind’ qualification is interpreted quite liberally by the IRS. As long as you are exchanging business property for other business property, you are in good shape. Property outside of the USA is not considered ‘like-kind’ to property in the USA, and property acquired for an immediate resale does not qualify.
45-Day Identification Period
After you sell your old property, you have 45 days to identify your replacement property. If you fail to find a new property in time, you will not be able to qualify for a 1031.
180-Day Exchange Period
You must close on your replacement property within 180 days. This includes the 45-day identification period as well, so if you waited until day 45 to identify your new property, you have 135 days left to close. Generally speaking, the purchase price of the replacement property must be greater than or equal to the value of the relinquished property. However, there are exceptions to this.
When doing a 1031 exchange, your replacement property (or properties) must meet the requirements of at least one of these three rules:
You can invest in three different replacement properties, without any regard to their value.
You can invest in as many replacement properties as you want. However, the total value of the replacement properties cannot be more than twice the value of the relinquished property.
You can invest in as many properties as you want, as long as the replacement properties are worth at least 95% of what the relinquished property is worth.
Again, as long as you satisfy one of these three conditions, you qualify for a 1031 exchange.
Another important element of the 1031 exchange is that you cannot receive the cash from the sale of your relinquished property; it has to go through a qualified intermediary. Just as you have 45 days to identify your replacement property, you also have 45 days to identify your intermediary. The funds from the sale go directly to the intermediary, who then sends the funds to the buyer on your behalf. The intermediary also receives the replacement property and transfers it to you.
If there is cash left over after the intermediary acquires the replacement property, it will be taxed as a capital gain. This is called a “cash boot.”
There can also be a situation through which you pay a “mortgage boot.” For example, if you had a loan on your relinquished property for $500,000, and your new loan on the replacement property is $300,000, then the difference–$200,000–is taxed as a capital gain.
Any gain that occurs when you sell depreciable property is taxed as ordinary income. For example, if you exchanged an improved self-storage facility for undeveloped land in Tampa, the depreciation that you previously claimed on your improved facility is now recaptured as taxable income.
If you are a self-storage owner with multiple facilities, using 1031 exchanges is a no-brainer. Amazingly, there is no limit to the amount of times you can use these exchanges, so in theory you could roll over your investments for a very long time–until you eventually cash in and pay a long-term capital gains tax (15%).
An excellent way to defer taxes and increase your self-storage facility’s cash flow is to use an asset depreciation technique known as cost segregation.
Cost segregation is the process by which engineers and accountants identify construction costs and portions of a building that the federal tax code considers to be “personal property” or “land improvements.” Once these construction-related costs are identified, you can depreciate them over a shorter tax life (five, seven or 15 years) compared to the building’s tax life (generally 27.5 or 39 years).
For example, by using cost segregation, some exterior site improvements–such as landscaping, paving and exterior lighting–can be depreciated over 15 years. Likewise, many interior assets–floor covering, lighting and some millwork–can be depreciated over five or seven years.
Whenever you buy a new property, be sure to get a copy of the engineering report, as this will segregate all the property’s assets into four distinct classes:
- land improvements
- personal property
- building components
Then you can depreciate all of your land improvements and personal property over a shorter period of time. Due to the time value of money, this can potentially save you a fortune.
If you do not have access to an engineering study, you may want to hire your own CPAs and engineers to do a segregation study. These studies can be quite expensive, ranging anywhere from $10,000 to $25,000, but are often very well worth it. As a general rule of thumb, if the expenditures for your building’s structure are greater than or equal to $750,000, you should conduct an engineering study.
As a caveat, cost segregation often triggers the tax code’s recapture provisions, so don’t use it too aggressively; if you do, you run the risk of receiving phone calls from the IRS.
Diagram courtesy of investmentpropertycentral.org.