What Is a 1031 Exchange?

If you're thinking about selling an investment property, a 1031 exchange may be a good option to consider. A 1031 exchange — named after section 1031 of the U.S. Internal Revenue Code, which provides the tax deferral treatment for qualifying exchanges — is a type of commercial real estate transaction that allows an investor to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds from the sale into the acquisition of a similar property, making the 1031 exchange a powerful tool for savvy investors. 

How Does a 1031 Exchange Work?

Simply put, a 1031 exchange allows a property owner to offload an investment property and use the equity from that sale to purchase a new, similar property, deferring 100% of capital gains taxes in the process. By reinvesting the proceeds from the sale of an asset into the acquisition of a similar property, the normal capital gains taxation that is typically associated with such a sale no longer applies, as the transaction is considered to be an exchange and not a sale. As far as the IRS is concerned, the exchange of one property for another allows for the taxpayer to avoid the tax of any sale. Instead, the transaction qualifies for deferred capital gain treatment. 

In order to execute a 1031 exchange, there are a few guidelines that must be followed. For starters, the asset that will be exchanged must have been held solely for business or investment purposes. Next, the property that will be acquired must be like-kind — meaning it must be of a similar use or nature to the property being exchanged (i.e. exchanging a vacant lot for a vacant lot, or a rental property for a rental property). Additionally, the target property must be of equal or greater value to the original asset. 

Finally, 1031 exchanges must be completed within a certain time frame. An investor is typically given a period of 45 days from the sale of the first property in which they must identify the replacement property for the exchange. Furthermore,the actual acquisition of the replacement property must be closed within 180 days of the sale. 

It is important to note that the actual exchange must be performed by a qualified intermediary. There are strict title requirements that must be adhered to – most notably that both titles cannot be in the same name at the same time. 

What Is the Purpose of a 1031 Exchange?

A 1031 exchange can be one of the most useful strategies in a commercial real estate investor’s arsenal. Simply put, selling an asset actually reduces an investor’s buying power, as asset sales can be taxed upwards of 20% or even 30%, based on federal and state tax rates. Because of such heavy taxation, the total profit of the sale of an investment property is typically at risk of being reduced to nearly 70% of its original worth. This is where the 1031 exchange really shines.

SEE ALSO: Federal Tax Implications for Commercial Real Estate in 2022

Executing a 1031 exchange is the perfect way for an investor to hold on to the equity they’ve built up in an asset and actually grow their investment without losing profits to Uncle Sam. By deferring capital gains tax obligations, an investor is able to basically reinvest the government’s due tax dollars into a new real estate investment from which they can continue to earn returns on that capital without having to pay anything to the government — besides the possible tax obligation owed if, in the future, the investor does decide to finally sell the asset outright.

Beyond capital gains tax deference, the 1031 exchange also negates the depreciation recapture rules of a sale as well. Typically, when a property is sold, any accumulated depreciation is “recaptured” from the sale and is then classified as taxable income. Since the 1031 transaction is considered to be an exchange and not a sale, the IRS’s depreciation recapture rules are also avoided using the strategy. 

When Should a 1031 Exchange Be Considered?

Besides simply saving on the tax bill, investors should consider the use of a 1031 exchange as a viable exit strategy when there are other investment opportunities on the table. The strategy not only provides the perfect way to offload a property without paying taxes on the sale, but also to grow an investment portfolio in the process. 

Since the rules of the exchange dictate that the replacement property must be of greater or equal value, investors have the opportunity to actually trade up when exchanging properties — utilizing more of the capital from the sale of their asset for the new investment than they would  have been able to after a typical sale. 

Advantages of a 1031 Exchange

There are a few advantages of a 1031 exchange:

1. Deferral of capital gains taxes and depreciation recapture

2. No limit on the number of exchanges an investor can make

3. Exchange can be made for a property of greater value, increasing the value of an investment portfolio

Disadvantages of a 1031 Exchange

There are also some disadvantages of a 1031 exchange:

1. This type of sale has a strict time frame for eligibility and property exchange.

2. Once the investor finally sells the asset, they will eventually have to pay capital gains taxes on the deferred gain — a disadvantage if the investment property has appreciated significantly in value.

3. It is a complex process that requires a qualified intermediary to execute.

Important Considerations About 1031 Exchanges

Appreciation and Depreciation

When depreciation has occured, it is often a sign that the property should be released from an investor's portfolio in an effort to stop any further losses and to regain investment power. in this scenario, using a 1031 exchange is the best way to maximize an investor's buying power for the next investment.

For an asset that has appreciated considerably, it may prove more beneficial to exchange it for a new property that has greater upside potential. In a low interest rate environment, this strategy is particularly advantageuos as it allows an investor the potential to obtain an asset with greater income and possible long-term appreciation at a lower cost than what would normally be possible.

Reverse Exchanges

Holding the titles of both the property that is up for sale and the replacement property at the same time is enough to disqualify an exchange. In the event of a delayed payment from the sale of the relinquished property — and a subsequent delay of title transfer — the reverse exchange offers a solution for investors.

In a reverse exchange, to avoid having both properties of the exchange titled in the same name at the same time, the replacement property goes into an exchange accommodation titleholder or EAT. The EAT is typically in the form of an LLC, and the profit and title is held by this LLC until the title of first property is officially relinquished.

The Delaware Statutory Trust

The Delaware Statutory Trust (DST) offers an opportunity in the form of a special class of properties that can be used as replacement properties in a 1031 exchange that are structured as securities. Instead of a like-kind property, investors purchase interests in the trust — which holds property titles and guarantees the commercial mortgages. Through this strategy, an investor can gain access to more expensive properties than they would have been able to afford on their own. Properties in a DST can include retail assets, office buildings, and apartment complexes, just to name a few, all typically valued in the $5 million to $50 million price range.