In November 2023, the commercial mortgage rates are hovering between 7% and 8%— near the same residential mortgage percentages that have been dominating the headlines. As a hotel investor, you already have to juggle multiple real estate adjacent costs— mortgages, maintenance, improvements, and the costs of buying and selling new holdings. Using a 1031 exchange can help minimize many of those conventional expenses by:
- Reducing or wholly deferring the capital gains tax of selling a property
- Giving you more flexibility as you expand or contract your commercial holdings portfolio
- Offering significant financial incentives for your organization to stay the course on like-kind investments
But in today’s economy of rising inflation and mortgage rates, it offers even more powerful advantages. Keep reading to learn more about the value of a 1031 exchange for your hotel properties, how to use this mechanism, and why it’s so important in periods with high mortgage rates.
A Quick Overview: 1031 Exchanges for Hotels
A 1031 exchange refers to the deferred tax mechanisms explained in IRS Tax Code Section 1031. In plain terms, you can use the profits of a commercial property sale to purchase a like-kind property without paying capital gains tax along the way. Since capital gains taxes can reach up to 20%, this represents a significant amount of capital that might have otherwise been taken from your purchasing power.
Benefits of 1031 Exchanges for Hotel Owners
The primary benefits of a 1031 exchange are clear for all commercial property owners. But it’s also important to consider the practical benefits for hotel investors:
- You can offload outdated properties or properties that are expensive to maintain by selling them and putting the funds toward properties that better suit your new portfolio goals. This can increase your cash flow and profitability.
- You can “shrink,” or consolidate, your portfolio by selling multiple hotel properties and pooling the funds to buy a higher-value property. This simplifies your holdings while still maximizing your tax savings.
- Shift with the market. Whether you focus on small, bespoke hotels and inns, large franchises, or hotels near luxury locations, you can refine your portfolio to meet new goals without losing capital to capital gains taxes along the way.
The Key Benefit in 2023 and 2024 Markets
If you’re considering purchasing a new hotel property in today’s market, the high commercial mortgage rates pose a significant challenge. Consider a $2 million purchase with a $400k down payment. At a 6% annual interest rate, your P&I payment will be approximately $10,000 a month. At an 8% interest rate, it balloons to over $11,700 for the exact same property.
The more you can do to shrink the size of your commercial mortgage for any new holdings, the better. 1031 exchanges allow you to transfer capital from one property to another while losing as little of it as possible. If you purchase a property of equal value to the proceeds, you can minimize or eliminate mortgage costs. Even if you purchase a property of higher value, you minimize the money lost on paying interest.
For many investors, it’s not the cost of the property itself that lowers your purchasing power and ability to attain new holdings— it’s the interest rates that limit how far your dollars can go.
Drawbacks of 1031 Exchanges for Hotel Owners and Investors
There are no penalties or financial downsides to using a 1031 exchange. However, there are restrictions and stringent requirements that can make accessing the tax savings difficult. Some of these challenges include:
- More complex tax documentation, which can increase the risk of errors and associated penalties
- Often requires a qualified intermediary, adding complication and expense until you find the right partner
- There are strict deadlines: Within 45 days of the property sale, you need to identify a replacement purchase, and, within 180 days, the deal must be closed.
- Finding a property equal to or more than the current holding so you don’t pay capital gains on the remaining portion of the sale proceeds
These difficulties are often more than outweighed by the tax savings, but they’re important to keep in mind.
How to Manage a 1031 Exchange for a Hotel Property
Utilizing the tax provisions in IRS Tax Code Section 1031 is simple on the surface, but it quickly becomes complex. Working with a qualified intermediary early on in the process can help ensure you follow all the requirements, hold the funds properly in escrow during the transactions, and finalize the transactions well within the deadlines.
The basic process includes these steps:
- Decide which property/ies you want to sell. These must be commercial holdings. Ideally, also determine how much money you expect to make from the sale.
- Identify the property you’re going to purchase with the funds. Be sure this is a property you can close on quickly.
- Use a qualified intermediary to manage the process. This third party will hold the sales funds in escrow, ensure you meet the deadlines, and advise you on the tax process. Opt for a brokerage that specializes in hotel properties so you have an expert with the right knowledge for your industry.
- Decide if you will put all of the tax-deferred proceeds toward the purchase of the new property, if you’ll use some of the proceeds for immediate improvements (which is ideal if you purchase a lower-value property), or if you will have leftover funds that will incur the capital gains tax.
- Complete the sale within the timeline and file IRS Form 8824 in your tax returns to comply with IRS requirements.
Tip for Today's Market
Depending on the area and niche, you may be in a seller’s market. It may take you some time to find a property you want to purchase and have your offer accepted. If you’re purchasing a new construction, there will also be significant delays because there is still a construction bottleneck. Consider making a reverse exchange: you buy the property first and then sell the property that qualifies for the 1031 exchange.
Alternatives to 1031 Exchanges for Accessing Tax Benefits
Property investors can access multiple mechanisms for tax savings. Each one requires a different strategy to fully take advantage of it. Some options include:
- Selling your properties through installment sales, which spreads out and even sometimes lowers the total tax burden
- Investing in Delaware Statutory Trusts (DSTs) instead of stand-alone like-kind properties. This still involves a 1031 exchange but grants you more flexibility in how you grow your portfolio.
- Purchasing property in opportunity zones, which may give you access to regional grants, incentives, and tax breaks. This also uses a 1031 exchange while offering more flexibility. This podcast walks through the mechanics of a recent case study involving a 1031 to OZ investment.
Using a 1031 Exchange in the Future: Grow With the Economy
1031 exchanges have conventionally been powerful tools for transferring capital and funds without incurring costly capital gains taxes. Today’s economy makes them an even more vital option due to turbulence in the real estate market and rising interest rates. At NewGen Advisory, LLC, we help hoteliers and investors manage 1031 exchanges and get the most out of their sales proceeds. Reach out today to apply the benefits of 1031 exchanges to your real estate holdings.