1031 Exchanges
A 1031 exchange allows an owner of real property held for investment or business use to sell it and defer the taxes that would otherwise be due on the gain: federal capital gains tax (a top long-term rate of 20%), tax on unrecaptured Section 1250 gain from depreciation (up to 25%), the 3.8% net investment income tax for higher earners, and state tax where the state follows the federal rule (California's top rate is 13.3%). The tax is deferred, not eliminated. A primary residence does not qualify.
Rather than pay these taxes, the investor reinvests the proceeds through a qualified intermediary, who must be engaged before the sale closes and who holds the proceeds. Replacement property must be identified within 45 days of the sale and acquired by the earlier of 180 days or the due date (with extensions) of the tax return for the year of the sale. To defer all of the gain, the replacement property generally must be of equal or greater value and all of the net proceeds must be reinvested. Like-kind exchanges have been part of the federal tax code since 1921.
The idea behind it is that when an investment property has built up substantial equity, the owner can sell it and exchange into property that better fits their current goals, for example for potential income, diversification or less hands-on management, without first paying tax on the gain. None of those outcomes is assured.
“Swap ’till you drop” is a term often used to describe a strategy in which a real estate investor continues to exchange investment real estate for life. Under current law, heirs may receive a stepped-up basis to fair market value at death, which can mean the deferred capital gains and depreciation recapture are not taxed to them. Tax law can change, and estate tax is a separate question for your estate attorney.
Potential Cash-Flow Benefits
To weigh the potential cash-flow effect of a 1031 exchange, it helps to first work out what the current property actually earns. Many owners measure it as net cash flow divided by what they paid or put down for the property. A more realistic measure compares net cash flow with the current equity in the building, based on its estimated value, and counts the value of the owner's own time, budgeting for unforeseen repairs and rising expenses. Many long-term owners find that figure is lower than they expected.
For investors with smaller amounts of equity, it can be hard to find income-producing real estate of any size. Fractional ownership, such as a Delaware Statutory Trust interest, lets an accredited investor own a share of larger, professionally managed real estate than they might buy alone. Any distributions from a DST are potential and not guaranteed, and they can be reduced or suspended.
DST investors have no day-to-day management responsibilities, because the sponsor and its property manager run the property, and investors have no say in management decisions. Sponsors typically set aside reserves for repairs and improvements when a property is purchased, and may add to them from cash flow as available. Reserves can prove insufficient. Any reserves remaining when the property is sold are generally distributed to owners according to their pro rata interests.
Tax Benefits
If you are a long-term owner of highly appreciated investment property, it is also important to consider the tax side of a 1031 exchange. A properly structured exchange can defer the capital gains tax and depreciation recapture that would otherwise be due, and it can move equity out of a property that has little depreciation left into a replacement property with a new depreciation schedule.
Depreciation on replacement property may offset some of the income it produces, but depreciation also reduces basis and increases the gain that is eventually taxed, and the amount varies by property and by investor. Ask your own tax advisor how it would apply to you.
Potential Appreciation Benefits
A 1031 exchange lets an investor reposition equity from one market or property type into another without first paying tax on the gain. Whether any replacement property appreciates depends on the market and the property, and it may lose value. Leverage and value-add business plans increase risk as well as potential return.
DST interests are offered only by private placement memorandum to accredited investors. They are speculative and illiquid, distributions are not guaranteed, fees reduce returns, and investors can lose some or all of their investment.
1031 Risk Disclosure:
- No strategy is assured of success or of meeting its objectives.
- Loss of value: all real estate investments can lose value during the life of the investment.
- Change of tax status: the income and depreciation from an investment property may affect the owner's tax bracket or tax status. An unfavorable tax ruling may disallow the deferral of capital gains and result in immediate tax liability.
- Foreclosure: any financed real estate investment can be lost to foreclosure.
- Illiquidity: DST and other fractional interests used as 1031 replacement property are commonly sold through private placements and are illiquid securities. There is no secondary market for these investments.
- Reduced or suspended distributions: like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, distributions may be reduced or suspended.
- Fees and expenses: the costs of a transaction may reduce investor returns and may outweigh the tax benefits.
Common questions
What taxes can a 1031 exchange defer?
Federal capital gains tax, tax on unrecaptured Section 1250 gain from depreciation, the net investment income tax for higher earners, and state tax where the state follows the federal rule. The tax is deferred, not eliminated.
Does a primary residence qualify for a 1031 exchange?
No. A 1031 exchange applies to real property held for investment or business use, and a primary residence does not qualify.
What is required to defer all of the gain?
To defer all of the gain, the replacement property generally must be of equal or greater value and all of the net proceeds must be reinvested. Proceeds you keep are generally taxable to the extent of the gain.
How long have 1031 exchanges been part of the tax code?
Like-kind exchanges have been part of the federal tax code since 1921.