Experienced real estate investors are familiar with the ins and outs of the 1031 exchange, a method by which an investment property can be swapped for another (usually larger) one. These transactions need to be carefully structured and are even more complex than a property sale and subsequent purchase, with timelines that need to be closely adhered to and significant regulatory requirements that must be followed.
So why bother?
Let’s take a look at 11 reasons why most professional investors would do well to consider a 1031 exchange.
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Reasons 1, 2 and 3: Taxes, taxes, taxes
By far the most compelling reason for most investors to structure their transaction as a 1031 exchange is that it allows them to defer the payment of capital gains taxes on the original sale. An investor who bought a property for $800,000 and is looking to sell it for $1.2 million would be facing a tax bill on the $400,000 capital gain. But by identifying a replacement property and designating the proceeds of the sale of the relinquished property to pay for it, the taxpayer defers payment of the original capital gains tax indefinitely.
A 1031 exchange also allows the deferral of another form of tax: depreciation recapture. When a property is sold, the depreciation that has been taken on the property is generally taxed at 25%. But selling the property as part of a 1031 exchange permits the deferral of this tax as well. Since the depreciation recapture tax rate tends to exceed capital gains tax rates, this benefit can support the benefit of the 1031 exchange further.
Finally, it’s important to realize that the deferrals of these taxes are indefinite and usually within the control of the taxpayer. The taxes do not become payable until the sale of the replacement property. But the investor can control that, either by holding the replacement property indefinitely, or by using a subsequent 1031 exchange to achieve further deferral. There is no limit to the number of 1031 exchanges available to any investor, so in theory, the exchange can be used to defer the payment of taxes for their lifetime.
4. Upsizing your portfolio
Another primary advantage to using a 1031 exchange is that it permits the investor to increase their real estate portfolio without needing to commit additional investment money to do so. The additional equity created by the capital gain in the original property is redeployed in lieu of requiring the investor to provide additional capital for a subsequent purchase. A virtuous cycle of consistently upsizing properties expands the investors' velocity of wealth creation over the long haul.
5. Expanding your portfolio
Similar to a traditional one-for-one upsizing, a 1031 exchange can be used to offload one property for several smaller ones, depending on the investor’s needs. So a large apartment building in a city with a value of $2 million could theoretically be exchanged for three smaller multifamily housing units with an aggregate value of $2 million; the units could be on the same block or in three different cities in three different time zones, affording multiple options to fulfill the investor's needs.
6. Responding to market conditions
A 1031 exchange, or “like-kind” exchange, permits investors to respond to changing market conditions by changing the nature of their holdings. Many real estate investors have done just that in recent years, choosing to forsake the challenges of the commercial real estate market by exchanging office properties for residential real estate holdings, preferring their odds of high occupancy rates in a time when working from home has become increasingly popular.
Other investors have gravitated toward different geographic locations as they see current holdings situated in more challenging scenarios. A 1031 exchange affords investors the flexibility to respond to fluctuating market conditions by altering their investment approach.
7. Using a DST to move away from hands-on management
A Delaware statutory trust, or DST, is a legal entity created as a trust under Delaware law, allowing investors to team with other investors in the ownership of one or more investment properties that are professionally managed. While some investors enjoy the day-to-day management of their portfolio properties, others are content to hand over the management and decision-making responsibilities to a team of professionals.
DSTs can be used to successfully complete a 1031 exchange and address the desire of many real estate investors to reap the rewards of a well-run real estate portfolio without the headaches of actually managing it themselves.
8. Using a DST to achieve (fractional) ownership of otherwise unattainable properties
So you’ve decided to exchange out of your $1 million office building and would like to invest in a luxury apartment building on the Upper West Side of Manhattan. The bad news is that $1 million won’t even buy you a single unit in the building, much less an entire building.
But DSTs can be used to take part in such a transaction anyway, as your $1 million will be combined with other investors’ money, enabling you to have partial ownership of a property that would otherwise be out of reach. Investors often opt for DSTs to access premium real estate opportunities that might otherwise not fit within their financial profile.
9. 1031 exchanges as an estate planning tool
As we mentioned, the ultimate payment of capital gains taxes on the sale of an investment property is almost entirely in the control of the investor, who can usually control whether they choose to sell or, even in the case of a sale, can use 1031 exchanges to further defer taxes. But the ultimate deferral occurs with the death of the investor: Upon death, the investment property in question receives a step-up in cost basis, so that the heirs do not also inherit the previously deferred tax liabilities.
It has been said that the only two certainties in life are death and taxes. However, the 1031 exchange is a process that allows you to defer paying taxes on the sale of certain types of property by reinvesting the proceeds into another property.
10. Using a 1031 exchange on a vacation home or a second home
It used to be relatively commonplace to use a 1031 exchange to swap one vacation home for another, and while Congress tightened the loopholes considerably in 2004, they didn’t eliminate them entirely. It’s still possible to turn a vacation home or a second home into an eligible investment property with the appropriate level of planning, usually by renting it out for a year before exchanging it for another property. Assuming you maintain the proper records documenting the income from tenants during that time, it’s likely that a 1031 exchange would then be permissible.
It’s important to note, however, that simply offering the house for rent without actually renting it to a tenant will not pass muster with the IRS.
11. The ultimate goal: Facilitating the growth of wealth
By deferring capital gains taxes, avoiding depreciation recapture, improving the quality and size of investment portfolios and generally putting more investment dollars to work for them, investors can use 1031 exchanges to dramatically increase the rates at which their wealth increases.
Of course, the IRS doesn’t offer tax breaks without a bevy of conditions, and 1031 exchanges are no exception. I’ve written extensively about the strict timelines that govern the deadlines by which replacement properties must be identified and the exchange must be completed and about the significant terms and conditions involved that require the use of third-party professionals to facilitate 1031 exchanges.
It’s absolutely critical to assemble a knowledgeable, experienced team to assist you with any 1031 exchange and the potentially lucrative benefits of a successful exchange can pay for the costs of the transaction many times over. If you are an investor and wish to gain more knowledge, you can participate in our 1031/DST Masterclasses.
Daniel C. Goodwin, Provident Wealth Advisors and AAG Capital, Inc. are not attorneys and do not provide legal advice. Nothing in this article should be construed as legal or tax advice. An investor would always be advised to seek competent legal and tax counsel for his or her own unique situation and state-specific laws.
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