1031 Exchanges for Investors: How to Play the Long Game

With inflation a continued concern, and the market heading into bear territory, investors are looking at property as a way to safely diversify their portfolios. And reasonably so. Real estate allows for the steady accumulation of wealth in several ways. Real estate tends to be resistant to inflation, typically grows in value over time, and can be income generating as well. There are also powerful tax benefits associated with real estate that allow investors to build their asset base while minimizing – or even avoiding – tax obligations. 

If you’re a real estate investor with increased equity due to the rising property values of the past few years, and are wondering whether it’s time to “cash out”, now is a good time to consider a 1031 Exchange as a way to acquire new property assets – while avoiding those capital gains taxes.

What is a 1031 Exchange?

A 1031 Exchange (also known as a Starker exchange or like-kind exchange) is a way to defer taxes when purchasing an investment property. Essentially, when you complete a 1031 Exchange, you “swap” your existing property for a new one. Unlike other asset swaps, where tax obligations arise at the point of sale, a 1031 Exchange allows you to “roll over” capital gains from your current investment property to the new property. In fact, you can continue to roll over these capital gains indefinitely as you purchase new properties. Assuming you meet all the terms of a 1031 Exchange, you’ll only have to pay capital gains if you eventually sell your portfolio without completing an exchange.  

As with all matters involving taxation, a 1031 exchange has a complex set of rules and restrictions; below is a list of those restrictions and general guidance or ‘rules of thumb’:

• The property has to be an investment property. Your personal residence cannot be used in a 1031 Exchange. Generally speaking, you should also have held the property for at least a year. 
• The property has to be “like kind”. Real property in the US can typically be exchanged for real property (for example, an apartment block can be exchanged for a storage facility), but cannot be exchanged for something else, for example international property or another asset class.
• The owner (taxpayer) of the property has to be the same. Because a 1031 Exchange is a continuation of ownership, generally the name on the title should be the same – whether it’s your name, an LLC or a trust. 
• Capital gains may be owed if the purchased property is valued at less than the property “exchanged” to purchase it. This difference in value is known as “boot”, and may be subject to capital gains. 
• If the new property is owned by a “related” party, there are additional restrictions to how long that property has to have been held, and how the property was paid for. This is to avoid related parties from taking advantage of 1031 Exchanges. 

Your lawyer or CPA can help you ensure that you’re meeting all of the requirements for a 1031 Exchange.  

Completing a 1031 Exchange

If you’re considering leveraging the increased value of your current investment property into a new one through a 1031 Exchange, it pays to have all of your ducks in a row first. This is because there is a time limit on 1031 Exchanges: you have just 45 days to identify the potential replacement property (or properties) following the sale of your property. While you do not need to be under contract on the potential replacement properties, in today’s low-inventory real estate market, it is wise to have a clear idea of the potential replacement properties prior to closing. The replacement property purchase (or purchases) must be completed within 180 days of selling the original property. If you do not identify any properties within the 45 day period, or close within the 180 day period, the exchange will be canceled and you will owe capital gains taxes. 

Ideally, you want a property that is equal to or greater in value than your existing property. This avoids “boot”, and also allows you to improve your overall portfolio – for example, trading a duplex up to an apartment complex. Note that there are some IRS rules governing the value of appropriate replacement properties. 

Over time, you can build your portfolio by using 1031 Exchanges to invest in increasingly valuable income generating properties, with the long-term goal of exchanging your properties into hands-off, turnkey investments such as a Delaware State Trust (DST) or NNN (triple net lease) property. 

If you’re looking to complete a 1031 Exchange, you’ll need a qualified intermediary to facilitate the transaction by “holding” the transaction funds in escrow. Leaders Title can assist you by-and-through our sister company and qualified intermediary – Title Exchange Services, LLC. There can be a great deal of complexity with a 1031 exchange, and it is important to choose the right partner to help ensure that you meet the requirements of a 1031 Exchange. For more information, talk to our team today.