The Basics of a 1031 Exchange

Real estate investors hate paying taxes, as do most people. Luckily for them, Section 1031 of the IRS tax code exists.

1031’s allow investors to sell investment property and use all of the proceeds to purchase new investment property, all while deferring capital gains tax associated with the sale. To qualify as an exchange, the relinquished and replacement properties must be qualified as “like-kind” properties, meaning you must exchange an investment or business property for another one. Like-kind property must be real property that has been and will be held for productive use in the investor’s trade/business, or for investment. A primary residence does not fall into the category of “link-kind” property. However, vacation homes and rental properties may qualify.

In general, “like-kind” property includes the following: multifamily apartments, healthcare, self-storage facilities, retail centers, industrial warehouses, student housing, senior living, and hospitality.

1031 Exchange Requirements

To avoid paying capital gain taxes in an exchange, investors must always do the following things:

1. Purchase a property (or properties) of equal or greater value
2. Reinvest all of the equity into the replacement property
3. Obtain equal or greater debt on the replacement property
4. The steps above must be completed within 180 days of closing on the relinquished property

The Exchange Process

1. Seller sells a property to a buyer
2. Seller contacts a qualified 1031 intermediary and enters into an agreement to do a 1031 exchange
3. At closing of the relinquished property, the funds are wired to the qualified intermediary
4. The exchanger (formerly seller, now the buyer) must identify 3 possible replacement properties in writing within the 45 day identification period (which begins on the date the relinquished property was closed)
5. The exchanger has a maximum of 180 days to acquire the replacement property
6. The exchanger signs a contract to purchase the replacement property with the seller and the exchanger assigns their rights in the purchase contract to the qualified intermediary
7. At closing of the replacement property, the qualified intermediary wires the exchange funds to complete the exchange

Reasons to Exchange

• Defer taxes
• Build & preserve wealth
• Expand into other real estate markets locally or nationally
• Improve cash flow
• Estate planning for heirs
• Improves purchasing power
• Diversify or consolidate a real estate portfolio

Alternative 1031 Strategy

In today’s market, the biggest risk to successfully executing a 1031 exchange is finding and closing on a replacement property. Inventory of suitable properties is low in today’s market, making it difficult to identify 3 replacement properties. If an exchanger isn’t able to identify properties in which they would like to purchase, they may opt to exchange into a DST, also known as a Delaware Statutory Trust.

DST’s permit fractional ownership of real estate, where multiple investors can share ownership in a single property or a portfolio of properties. A DST qualifies as a replacement property in a 1031 exchange. Think of it as investing into something sort of like a REIT but with more ownership of the asset(s) and less liquidity (typical hold period is 6 years).

Investors will often utilize a DST as a back up property for the 3 Property Rule required for 1031 exchanges. For example, during the 45 day property identification period, an investor could identify 2 investment properties to purchase, and then choose a 3rd property owned/operated through a DST. It costs the exchanger no additional money to do this, and it provides a layer of protection to the buyer/exchanger should the other 2 properties identified fall through.

Summary

As you can see, 1031 exchanges are a powerful tool for real estate investors. There’s a popular phrase in the rea estate investment world called ‘Swap until you drop.’ This is the strategy that’s enabled by the 1031 exchange, and investors love it. In theory, you can exchange properties over and over again until you pass away, deferring capital gains taxes along the way. Your beneficiaries could be left with an empire of real estate that started out as a single property but grew to a large portfolio, all because taxes were deferred over time.

Speak with your CPA, lawyer, investment manager or a qualified 1031 intermediary to learn more and see if entering a 1031 exchange is the right decision for you.

Sources: Inland Private Capital Corporation, Investment Property Exchange Services Inc