The process of investing in a hotel provides various investment options. There are several methods to acquire property. Exploring these different options will bring prospective buyers face-to-face with 1031 exchanges. As well as the alternative of opportunity zones.
The hotel industry is thriving and has a global value of more than $570 billion. Investors continue to keep their eyes open for a profitable hotel for sale. If they are lucky, they will begin the acquisition process. These hotel owners can gain an advantage by reviewing the benefits of 1031 exchanges.
What is a 1031 Exchange?
A 1031 exchange is a strategic swap of business properties that allows for deferring capital gains taxes. The name derives from the Internal Revenue Service (IRS) code Section 1031.
In a nutshell, the code describes business owners or property investors deferring federal tax. The deferral occurs on the grounds of exchanging real estate.
To quote the code, “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Understanding that not all property acquisitions are equal, there are different methods of a 1031 exchange.
The Main Types Of 1031 Strategies
There are different types of 1031 exchange strategies, each suiting different situations.
- Simultaneous exchange – investors can relinquish and close on a replacement property on the same day
- Delayed exchange – investors sell their property first and find a replacement property within a certain amount of time post-sale (this is the most common option)
- Reverse exchange – this method follows an investor buying a property first and then paying later
- Improvement exchange – an option when the new property costs less than the sold property, using the remaining funds to improve the bought property
Criteria to Qualify for a 1031 Exchange
Investors wanting to buy or sell a hotel and use the 1031 exchange approach need to ensure that the property qualifies. There are a few key considerations to keep front of mind that may limit the transaction.
- A 1031 exchange only applicable for investment or commercial property
- The potential replacement properties must be delivered in writing and delivered to the seller (or intermediary). The timelines is within 45 calendar days after closing the relinquished property
- All replacement properties must be purchased within 180 calendar days following the closing sale of the relinquished property
- Alternatively, the replacement properties must be purchased in line with the due date with extensions of the income tax return for the tax year that the relinquished property was sold. The timing applies to whichever occurs earlier
- Both properties must be in the United States
- Special rules apply when exchanging a depreciable property
- A qualified intermediary needs to hold the funds between transactions
How Hotel Investors Benefit from 1031 Exchange
There are many moving parts to gain the benefits of a 1031 exchange. However, the benefits for hotel investors are worth it. Here are a few of these benefits to consider.
Defer Capital Gains Tax
By deferring the payment of capital gains taxes through the acquisition of replacement property (or properties), investors avoid paying out almost a third of equity in taxes. A tax-deferred strategy is an effective strategy to build wealth.
Increase Cash Flow
Using a 1031 exchange when selling a lower value or underperforming property and investing in one that will be more profitable can increase your cash flow. Keep the money saved from the exchange and recommit it to your investment portfolio.
A 1031 exchange can help hotel investors diversify or consolidate their investments. The ability to sell a property and buy a new one (or more) without paying hefty capital gains tax allows for portfolio growth with fewer financial limitations.
If your portfolio of properties becomes difficult to manage, then a 1031 exchange can help to streamline investments. Selling time-consuming properties and buying hotels with forecasted potential can strengthen and grow your portfolio.
Using a 1031 Exchange to Buy a Hotel
A 1031 exchange transaction is a smart move for hotel investors who want to gain tax deferrals and diversify their portfolios. The process is based on sound tax policy. However, an experienced advisor needs to assist with the transaction.