Venturing into real estate can yield significant financial rewards. However, like most investment options, it comes with a common downside: taxes. Thankfully, unless legislative changes are made to the 1031 provisions, which have been around for over a century, astute real estate investors can indefinitely postpone capital gains tax payments through a 1031 exchange.
Derived from the section of the Internal Revenue Code outlining its numerous guidelines, the 1031 exchange allows an investor to defer tax payments by adhering to a set of stringent regulations. Here is an overview of the essential information needed to fully benefit from a 1031 exchange.
1. 1031 Exchanges Are Also Known as ‘Like-Kind’ Exchanges
According to Section 1031 of the IRC, a 1031 exchange is characterized by the swapping of real property utilized for business or investment purposes exclusively for another property of the same type or “like-kind” meant for business or investment. As per the code, real properties are generally considered “like-kind,” enabling the seller of a business property to effectively defer tax obligations by reinvesting the sale proceeds into another business property. For instance, a seller of undeveloped land can regard a rental property as “like-kind,” while an individual selling an apartment complex can acquire a medical building, which will also be deemed “like-kind” under the 1031 regulations.
In simpler terms, a 1031 exchange involves trading one property for another, with the second property taking on the cost basis of the first. The code aims to encourage reinvestment from one real estate asset to another while adhering to the “like-kind” condition. Consequently, investors cannot use the proceeds from a real estate investment to acquire a different type of investment, such as stocks or bonds. However, in specific instances, some oil and gas interests may be considered like-kind.
2. Time is Ticking
When considering a 1031 exchange, speed is indeed crucial, or at the very least, being well-organized is vital. You have a 45-day window from the date of the initial property’s sale to pinpoint a new property in which to reinvest the proceeds. Moreover, you only have 180 days from the original sale date to finalize the transaction on the new investment property. (Keep in mind, this is 180 days from the original sale date, not 180 days from when you identified the new property!) If you fail to meet either of these deadlines (such as identifying the new property on day 46 or closing the new transaction on day 181), you will be subject to capital gains taxes on the initial transaction. There are no exceptions.
3. Downsizing an Investment Isn’t Possible with 1031 Exchanges.
The stringent regulations governing 1031 exchanges necessitate that the replacement investment property must have an equal or higher value compared to the property being sold. Furthermore, to achieve complete tax deferral, the entire proceeds from the sale must be utilized to acquire the subsequent property.
For instance, if the initial sale is completed for $500,000, you cannot reinvest $300,000 into a new property and retain the $200,000 difference; the full $250,000 must be involved in the second transaction. If the replacement property’s value is not equal to or greater than the first property, the capital gains tax will be applicable to the entire relevant capital gain.
4. Four Distinct Transaction Structures Can Be Utilized.
Four Distinct Transaction Structures Can Be Utilized.
Depending on the situation, real estate investors typically employ five distinct types of 1031 exchanges to cater to their varying needs:
- Delayed Exchange, where one property is sold, and a subsequent property (or properties) is acquired within the 180-day time frame.
- Simultaneous Exchange, in which both transactions occur simultaneously.
- Reverse Exchange, where the replacement property is purchased before the original property is sold.
- Deferred Build-to-suit Exchange, where the proceeds are used to finance the construction of a new property tailored to the investor’s requirements.
Regardless of the option chosen by a real estate investor, the regulations governing 1031 exchanges remain fully applicable.
5. You Will Require Professional Assistance for This.
To guarantee that everything is executed in compliance with the stringent requirements of the IRS, it is essential to seek the help of a 1031 facilitator or qualified intermediary (QI). Many common errors made by investors attempting a 1031 exchange for the first time can be easily prevented with expert guidance. These errors include adhering to the crucial 45- and 180-day timeframes, choosing and identifying suitable properties for exchange, and managing funds between transactions.
Receiving the proceeds from the initial sale personally is a major mistake and will instantly result in capital gains tax liability, even if all other 1031 exchange rules are adhered to. Instead, employ a qualified intermediary to manage the funds on your behalf.
6. Is This Complex Process Really Worthwhile?
Let’s examine an example to demonstrate. We’ll discuss the situation of Alex, who wants to sell their $4 million apartment building that they bought for $1 million. We’re assuming the building has no mortgage, and Alex is looking at a 20% Federal capital gains tax rate.
The sale goes through at $4 million. Alex’s $3 million profit is taxed at 20%, costing $600,000. Alex also faces a net investment income tax of 3.8%, or $114,000 (since the transaction is in excess of $250,000), and since Alex’s state of residency is New Jersey he’ll owe $269,100 in NJ state taxes. This would mean Alex would owe $983,100 in taxes and reducing his profit from $3 million to $2,0169,00.
On the other hand …
Alex has the option to structure a 1031 exchange to obtain a new property. The proceeds from the $4 million sale are transferred directly from the escrow account to a qualified intermediary. Alex is given a 180-day window from the sale’s conclusion to identify and finalize the acquisition of a new investment property.
Alex has pinpointed three potential acquisitions:
- A shopping center with a $4 million valuation.
- An apartment building worth $2 million.
- A multifamily home valued at $2 million.
Within the 180-day time frame, Alex can choose any of the following options:
- Purchase the shopping center for $4 million and defer all capital gains taxes.
- Acquire both the shopping center and the apartment building for a combined total of $6 million, defer all capital gains taxes on the $4 million, and secure a $2 million loan to be divided between the two properties.
- Buy the apartment building for $2 million and the multifamily home for $2 million, deferring capital gains taxes on the combined purchase price of $4 million.
Do not overlook the significance of DSTs. In today’s investment landscape, numerous investors grapple with identifying appropriate replacement properties. A Delaware Statutory Trust (DST) represents a shared interest in a high-quality asset, which is passively owned and provided by a real estate syndication, typically known as a sponsor. The range of assets within a DST can vary from Class A apartment complexes (generally valued at $100 million) to medical facilities, self-storage units, RV parks, senior living communities, or even Amazon distribution centers. For investors seeking a more “hands-off” approach, DSTs can serve as an exceptional alternative.
7. A Final Approach: The Sole Method to Solidify Tax Deferrals Permanently
The 1031 exchange serves as a tax-deferral tactic rather than a tax-elimination strategy. Inevitably, when you decide to sell an investment property without reinvesting the proceeds through a 1031 exchange, the capital gains tax becomes payable.
However, there is an exception: Death.
Upon your passing, the investment property in your possession acquires a stepped-up cost basis equivalent to its prevailing market value. Consequently, your beneficiaries have the option to sell the property at that value with minimal or no capital gains tax liability. This approach offers a lasting resolution to a persistent issue and plays a significant role in the estate planning of numerous real estate investors, particularly if they never require liquidating their investment properties.