The Benefits of a 1031 Exchange:
Why the sellers of investment real estate should consider the 1031 exchange as an exit strategy
An IRC Section 1031 Exchange (“Exchange”) is a tax benefit that allows investors to defer the capital gains tax normally due on the sale of investment real estate or real estate held for productive use in a trade or business (sometimes as much as a 35% combined rate – state and federal). To achieve tax deferral, the same taxpayer selling the business or investment real estate must reinvest the net proceeds from the sale in “like-kind” business or investment real estate. Besides the monetary benefits from the indefinite deferral of capital gains tax, the 1031 exchange is a powerful tool that can be used to accomplish several other goals. Many times, it is asset quality/returns, market factors, quality of life issues, and strategic planning that drive the exchange transaction. This summary discusses exchange eligibility and several benefits/strategies for investors to consider.
Any type of real estate held for business or investment is eligible (“like-kind”) in a 1031 exchange:
Many investors and professionals tend to associate 1031 exchanges with only commercial real estate or large real estate deals. The truth is that the benefits of a 1031 exchange are available to any taxpayer selling non-owner-occupied real estate, held for investment or held for productive use in a trade or business. In a nutshell, these “held for” standards mean no personal use or flips. Most rental real estate should qualify for an exchange if the proper use/intent and holding periods are met (special rules for vacation homes or multi-family with part rental/part owner occupied). Because this article focuses on the benefits of a 1031 exchange, for more detailed background on the “like-kind” standard and the “held for” rules, we suggest that you read this “1031 Exchange Overview”, explore our Website, and read our article “10 Common Misconceptions About 1031 Exchanges.” If you or a client have questions or concerns about the 1031 exchange process or criteria, we encourage you to contact the experienced team of experts at Legal 1031.
Here are some of the main reasons why thousands of our clients have structured the sale of an investment property as a 1031 exchange:
Diversification by market or by asset type: Owning real estate concentrated in a single market or geographic area or owning several investments of the same asset type can sometimes be risky. A 1031 exchange can be utilized to diversify over different markets or asset types, effectively reducing potential risk.
Consolidation: Investors who own several different properties can bear the burden of administrative and maintenance responsibility. Considerations: How many different potential liabilities – roofs, windows, boilers, and other items is the investor responsible for maintaining? How far apart/away from home are these properties? Does the employment of management companies diminish returns?
Management Relief/Quality of Life: How much is the investor’s time worth? Similar to the logic behind consolidating, even owning one large rental property with several units can be management intensive. After years of being a landlord, many multifamily owners get sick of the “Four Ts”: tenants, toilets, termites, and trash. Many of these investors utilize the 1031 exchange to acquire replacement properties subject to a long-term net-lease under which the tenants are responsible for all or most of the maintenance responsibilities, there is a predictable and consistent rental cash flow, and potential for equity growth.
Build a Portfolio/Leverage up: In a 1031 exchange, pre-tax dollars are used to purchase replacement real estate. This provides the exchanger the ability to purchase replacement property with funds that would have otherwise been paid as capital gains tax on a sale of the property. The exchanger can potentially leverage such funds to substantially increase their purchasing power and wealth building potential. More equity can lead to a lower loan to value ratio and approval on the acquisition of a higher value property. As a long-term strategy, a 1031 exchange can be repeated indefinitely and combined with other tax strategies to build a portfolio.
Relocation: An investor or business can use an Exchange to move their investment to a different location for a variety of reasons that might include: retiring to another state; job relocation; more favorable market/lower local taxes; and local business incentives.
Cash Flow: An investor can utilize an exchange to transition built up equity to a better performing asset without realizing the tax consequences of the sale.
Estate Planning: Currently, it is possible to exchange like kind real estate indefinitely over a lifetime, continually deferring capital gain and transferring basis to each subsequent property until the taxpayer’s death. The subsequent heirs who inherit real estate, whether it has been part of a §1031 exchange or not, receive the “stepped-up” basis which is generally defined as the fair market value of the inherited property at the time of death. In this fashion, significant capital gains liability can be eliminated permanently with proper planning. In a nutshell, all the built-in gain on the replacement property, which transferred from the relinquished property goes away upon the death of the taxpayer. Also, utilizing an exchange, an investor can potentially sell and divide a large property into several smaller properties, one for each of their heirs, while minimizing capital gains tax.
Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary to facilitate your exchange.
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