As a real estate investor, it’s hard to miss the phrase “1031 exchange.”It remains one of the greatest gifts in capital protection and tax shielding for serial investors.
But the name’s not very telling, is it?
In simple terms, a 1031 exchange allows equity to roll over from one real estate investment into another, deferring certain tax obligations. Any investor seeking to build wealth over time would be advised to explore how this strategy could work for them.
Despite the strictly enforced rules in the exchange, investors have increased flexibility with 1031 exchange options in 2021 and 2022. So let’s dive into what 1031 exchange options can do for you this year.
The Basics Of 1031 Exchange
Everybody knows that the devil feasts on taxes for lunch.
Back in 1921, the U.S. Congress passed an act under section 1031 on the Internal Revenue Code alleviating honest real estate investors from the devil’s lunch. Thus emerged the concept of a 1031 exchange.
For the past century, 1031 exchanges have allowed real estate investors to defer capital gains taxes and depreciation recapture taxes when they relinquish an asset in exchange for a like-kind property of equal or greater value within a specific timeframe.
What is a 1031 Exchange?
A 1031 exchange is a simple exchange of one investment property to another within a predetermined time frame and with specific fiscal benefits. Provided the replacement property is of the same nature and character, and certain conditions are met (we’ll get to these soon), investors are free to string these exchanges from one investment to the next and defer capital gains tax ad infinitum.
To better understand how a 1031 exchange works, let’s take a look at the process:
- An investor selects a qualified intermediary to handle the exchange
- The investor sells their investment property (also known as the relinquished property)
- Proceeds from the transaction are wired into a separate escrow account
- Within 45 days, the investor identifies and discloses up to three potential replacement properties
- Within 180 days, the investor closes on the purchase of at least one of these properties
- Escrow funds held by the qualified intermediary are wired to close the replacement property deal
- The investor benefits from deferred capital gains and depreciation recapture taxes.
The cost basis can be reassigned from the old property to the new one as many times as the investor wishes, making it an excellent tool to gain equity without losing capital to taxes – at least until a final sale is made.
When You Want a 1031 Exchange
People opt for 1031 exchanges for limitless reasons. It could be that you want an investment property with less responsibility; maybe you’re moving to a new city and prefer to keep your investments close, or perhaps you want to diversify your current real estate portfolio.
Estate planners use 1031 exchanges to consolidate multiple assets into one or divide one asset into several individual assets.
People opt for this exchange when they feel ready to sell their assets and reinvest in a like-kind real estate, and can work with the strict time limitations for the transaction. With this in mind, the structure and requirements of such a transaction will not necessarily be the right choice for everyone.
Importance Of Depreciation For a 1031 Exchange
Here’s a secret about depreciation: whether you have or have not claimed the tax benefits of depreciation during the investment term of your asset is of little concern to the Internal Revenue Service (IRS).
When you sell your property, you’ll still be required to pay a tax – known as depreciation recapture tax – on what you should have claimed on depreciation during your investment. That is unless you choose a 1031 exchange option, of course.
With a 1031 exchange, the cost basis of your relinquished property gets transferred to your replacement property, so you can defer depreciation recapture tax and capital gains tax. Recovering the depreciation value is considered a “gain” when you sell the property, so you declare this amount as income and pay the same rate as your income tax.
For example, let’s say you purchase a property at $750,000, and it depreciates at $20,000 each year. If you sell the property after the fifth year, you have been running at a loss of $100,000 (20,000 x 5), which offers you a tax shield on that capital value.
When you sell the real estate, the IRS recovers a portion of this as tax. You’d declare the $100,000 depreciation as income and pay income tax on it as you would with any other ordinary income.
This is known as depreciation recapture tax, and with a 1031 exchange, you can defer it to your next property.
Choosing a Property
When it comes to selecting your replacement property, the two most important things that come to mind are the time limitations and property-specific rules. Let’s take a look:
The two specific time frames to be aware of are 45 days and 180 days after the sale of the relinquished property. The 1031 exchange is contingent on both of these rules being met.
The 45 Day Rule
Investors have 45 days from the sale of the relinquished property to disclose the address of at least one and up to three replacement properties. These properties must have a single or combined value equal to, or greater than, the value of the relinquished property.
You’re not obligated to close on all three properties, provided the value on the closed deal/s remains equal to or greater than the sold property.
Identifying three alternatives reduces pressure and risk for the investor, should one potential fall though.
The 180 Day Rule
The 180-day rule runs concurrently with the 45-day rule, meaning both time frames begin the day you sell your relinquished asset. Inventors are granted 180 days to close on one or more of the chosen replacement deals.
Even when the 45th and 180th days fall on a holiday or weekend, investors must adhere to these time allocations to reap the benefits of a 1031 exchange.
Do you have bigger sights on your next investment move? Hungry for more than three replacement properties? This is allowed as well, within certain limitations as we outline below.
The 200% Rule
If you identify more than three properties in a 1031 exchange, the total value of all assets must not be greater than the value of 200% of your relinquished sale. So for example, if you sold your property for $750k and wish to identify five replacement assets, the total value of the five assets must not exceed $1.5 million.
The 95% Rule
This rule is the second part of the aforementioned directive: if you engage with the 200% rule, you are bound by the 95% rule.
When an investor chooses to identify more than three replacement properties they are obligated to close on 95% of the identified properties’ combined value within 180 days. This is undoubtedly trickier than managing a single property exchange, though has the potential for higher wins too.
As with our above example, this would mean you’re required to close on $1,425,000 of your targeted properties.
What Types of Properties Qualify for a 1031 Exchange?
The types of real estate that qualify for a 1031 exchange are diverse. Even though you must exchange your asset for a “like-kind,” the rules around this are flexible. Like-kind refers to the nature and character of the property, not the grade or quality of the asset. So it would be easy to exchange a rental apartment investment for a triple net lease commercial investment, for example.
Here are some of the property types you can use in a 1031 exchange:
- Raw land or farmland
- Commercial real estates, such as rentals, multifamily properties, offices, and retail assets
Note that all properties must be allocated for productive business or investment purposes. It’s not permitted to exchange a primary residence or vacation property.
Is an Exchange Right for You?
1031 exchanges are a favored option for serial investors with a keen interest in actively keeping their investment portfolios optimized. If you’re selling for a replacement asset of equal or higher value, if you’re planning your estate, or if you want to transition to an investment opportunity with fewer managerial responsibilities, then 1031 can be a great way to step forward.
But there are a few situations where a 1031 exchange may not be the right choice for you:
- If you do not plan to reinvest your money after the sale of an asset
- If you are selling a property at a loss, or if the property you plan to buy a less expensive than the asset you own
- If you are selling or purchasing a primary residence or vacation home.
If your next investment move is still in the gestation phase and you’re looking for 1031 exchange options to give you a more flexible investment vehicle through which you can meet your financial goals, take a look at some of these innovative choices worth considering.
What Are Your 1031 Exchange Options?
Delaware Statutory Trusts
Delaware Statutory Trusts (DST) add an edge to 1031 exchanges. A DST is a separate legal entity constructed under Delaware laws that allows an individual to hold title to one or more revenue-generating properties.
A DST offering could be any commercial property, such as residential, retail, or industrial parks.
They usually come with a minimum entry of $100,000 for 1031 exchangers and only $25,000 for cash investors.
They open the doors for an investor to attain a professionally managed, institutional-grade asset as a passive revenue generator with a 1031 exchange. The investor will receive superior risk-adjusted returns and has the freedom to disengage from daily asset management responsibilities.
The DST offers low-cost ownership with cash distribution potential and remote management opportunities.
Direct Purchase of Triple-Net (NNN) Properties
Purchasing triple net lease properties is another popular option for 1031 exchangers to attain an income-producing asset without the responsibility and hassle of property management duties.
Triple-net leases place the duty of property management, maintenance, and repairs in the hands of the tenants. The tenant is also responsible for expenses like property taxes, insurance premiums, utilities, and repairs. Triple nets work to the benefit of both parties because the tenants have more flexibility to outfit the property as they please, and the landowner doesn’t have to spend time and energy managing the asset. Instead, they can enjoy a passive income.
Triple net leases are usually long-term, with cost-of-living increases incrementally embedded in the lease agreement. Investors consider triple net properties some of the most stable and resealable real estate investments on the market.
According to Internal Revenue Procedure (2002-22), multiple tenants can undertake co-ownership of the replacement property provided the exchange adheres to certain rules and requisites. TIC owners essentially have the same rights as single-property owners.
This agreement is called Tenants in common (TIC), whereby two or more parties have an unseparated fractional interest in the real estate asset. Shares in ownership are not required to be equal and can be inherited by beneficiaries.
This option helps mitigate risk for investors who experience difficulties locating and closing an appropriate replacement property. With TIC 1031 exchange options, investors benefit from reduced risk in the face of timing limitations.
Qualified Opportunity Zone Funds
A Qualified Opportunity Zone Fund is an investment channel, facilitated as a partnership or corporation, for venturing into a Qualified Opportunity Zone property.
With a QOZ, the investor can move into other asset classes such as infrastructure development, local business, and other real estates, offering portfolio diversification leverage. Multi-asset Qualified Opportunity funds can provide multiple revenue streams from a single investment.
If investors have a knack for divine timing, it’s possible to marry a 1031 exchange with entry into a QOZ fund, which could also assist an eventual transition from real estate.
The process of exchanging into a QOZ is less laborious than into another real property. No qualified intermediary needs to be involved, and the investors have a full 180 days to make sure this investment opportunity is the right one for them.
Still Have a Question? Ask Us Today!
Of course, when you’re exploring all of your 1031 exchange options, there is a lot of fine print, and a keen eye is necessary to pick out all of the details that may be relevant to your proceedings.
This list is by no means exhaustive, but it offers a simple breakdown of the options available for investors to gain a favorable edge in their next real estate move.
If you have any questions about whether a 1031 exchange may be a prospect of interest, if you want to secure a NNN property for your 1031 exchange, or you seek guidance about how to move forward, get in touch with us today!
Our team of experienced experts is here to assist you along the way, and to help you discover the decisions that are the best for your financial future.