1031 Exchange for a Retail Strip Center

The tax on a depreciated strip center comes in two layers plus a surtax

Gain equals your net sale price minus adjusted basis, and after twenty years of 39-year straight-line depreciation the basis sits far below what you paid. Topic 409 sets the rates: depreciation comes back as unrecaptured §1250 gain at up to 25%, the remaining long-term gain is taxed at 0%, 15% or 20% by income, and §1411 adds 3.8% for income above $200,000 ($250,000 joint).

Hypothetical: a center bought for $2,000,000 ($1,500,000 to the buildings) twenty years ago has taken about $770,000 of depreciation and sells net for $3,500,000. Adjusted basis is about $1,230,000 and gain about $2,270,000: $770,000 at 25% is $192,000, $1,500,000 at 20% is $300,000 and NIIT on the full gain is about $86,000, roughly $578,000 of federal tax before state tax.

A fully deferred exchange postpones all three amounts; the depreciation history follows you into the replacement and comes due only on a later taxable sale, or never if the property is held until death and stepped up under §1014.

Paying off the center's mortgage creates boot unless the replacement carries as much debt

Publication 544 treats liabilities the buyer assumes or pays off as money you received, netted against debt you take on and cash you add. A $1,000,000 loan retired at closing therefore needs $1,000,000 of new borrowing or fresh cash on the replacement side, or the shortfall is taxed as if you had pocketed it.

Recognized gain from boot is taxed under the same layers, so even a modest cash-out can carry the 25% rate. Sponsors structure zero-cash-flow and cash-out DSTs with high non-recourse leverage precisely so an owner retiring a large loan can satisfy the debt-replacement test without a new bank underwriting.

Where three-to-five-tenant centers usually go: single-tenant net leases, industrial, multifamily, DST portfolios

Any U.S. real property held for investment is like-kind to the center, so the choice is about management and concentration rather than eligibility. A single-tenant net lease trades five small leases for one corporate tenant and a long primary term, an industrial or multifamily DST spreads rent over dozens of tenants, and DST interests qualify under Rev. Rul. 2004-86 provided the trustee's powers stay within the ruling's limits.

Because DST interests are sold in fractional amounts, one center's equity can be split across several trusts and asset classes; the 200% rule allows any number of identified trusts as long as their combined value stays under twice the center's sale price, and three can be named at any value. The asset-class overview and the DST versus direct ownership comparison cover what you give up in control.

CAM under-recovery, short shop leases and a tired parking lot show up in the buyer's price

Strip-center leases are usually net leases in which each tenant reimburses its share of taxes, insurance and common-area maintenance; CAM you never billed or capped too low reduces net operating income, and a buyer capitalizing that income pays less, shrinking the equity you have to reinvest. Deferred parking-lot, roof and facade work is priced the same way, and a lender's appraisal will flag parking below the zoning minimum for the tenant mix.

Short leases cut both ways: month-to-month mom-and-pop tenants make the buyer's financing harder, and a vacancy that appears during your 180-day window can lead the buyer to re-trade while your identified replacements sit under contract. Renew or extend the leases you can before listing, and avoid announcing that you must close by a certain date to satisfy an exchange.

• Reconcile three years of CAM billings against actual expenses before the buyer's accountant does.
• Collect estoppel certificates and lease abstracts for every tenant, including the month-to-month ones.
• Order a parking count and a roof and pavement inspection ahead of the buyer's due diligence.
• Line up replacement property before the center goes under contract; the clocks are not extendable except under IRS disaster relief.

Storefronts below and your apartment above: the sale splits between §121 and §1031

Reg. §1.121-1(e) treats a residential unit and separate commercial space as different portions of one property: the apartment you lived in for two of the last five years can take the $250,000 ($500,000 joint) exclusion, while the shops are business property that can be exchanged. Rev. Proc. 2005-14 orders the two: allocate basis and price the same way you allocated depreciation, usually by square footage, apply §121 to the residence share first, then apply §1031 to the commercial share and its depreciation.

Depreciation claimed on the commercial floor is never excluded under §121, only deferred, and an upstairs unit rented to a tenant rather than occupied by you is simply more exchangeable business property.

When your buyer is in a 1031 exchange, or you are, the contract changes but the price should not

A buyer completing their own exchange must close within their 180-day window and will ask for a cooperation clause and the right to assign the contract to their qualified intermediary; neither changes your proceeds, your deposit or the inspection contingencies. What changes is leverage: a buyer racing a deadline may pay for certainty, and a seller who advertises a deadline gives it away.

As the seller in an exchange you assign your rights under the contract to the intermediary before closing, the buyer acknowledges the assignment, and the settlement statement sends net proceeds to the intermediary rather than to you; touching the funds, even briefly, converts the exchange into a taxable sale under the constructive-receipt rules. A buyer's deadline is their problem, but your own exchange gains from an escrow long enough to line up replacements.

California sellers keep filing FTB 3840 for every year the gain stays deferred

California requires every taxpayer, resident or not, who exchanges California real property for out-of-state like-kind property to file Form FTB 3840 for the year of the exchange and each later year until the California-source deferred gain is recognized. Skip it without filing a California return and the Franchise Tax Board may issue a Notice of Proposed Assessment taxing the deferred gain with penalties and interest.

A strip-center owner who trades into DSTs holding property in five states therefore files the form annually, allocating the deferred gain across the replacements, until each interest is sold in a taxable transaction. Other states have their own conformity and withholding rules; see the state guides and the California page, and ask your CPA to calendar the annual filing because the obligation outlives the exchange by years.