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1031 Exchange

What Is a 1031 Exchange?

Simply stated, a 1031 exchange is a swap of one investment property for another, while deferring all or most of the capital gains that would otherwise be incurred on a regular sale of that property. To enjoy this benefit, the exchanger must reinvest all the proceeds on the sale of the relinquished property into another property of equal or greater value within the strict time periods codified by Section 1031 of the Internal Revenue Code.

Primary Benefit

This section of the Internal Revenue Code has preserved wealth and facilitated wealth building for investors for many years by reducing or eliminating the ‘transactional friction’ of capital gains. While there are always some transactional costs in the sale or exchange of property, this is a major hindrance to compound growth that can be substantially or completely deferred. The IRS has extended this benefit on the theory that an exchange of like-kind investment property continues the investment and shouldn’t be treated as a taxable cash-out.

Requirements for A Tax Deferred Exchange

  • Equal or Greater Value

    Exchanger must reacquire property of equal or greater value than the property relinquished and maintain equal or higher loan amounts. This is the general rule but there are nuances. For example, the exchanger can contribute additional cash to replace any debt that is not replaced in the new property acquisition.

  • No Actual or Constructive Receipt of Proceeds

    The seller may not receive or even constructively receive (even for an instant) any proceeds from the sale of the property before the exchange is complete. Sellers are therefore strongly encouraged to engage exchange facilitators called “Qualified Intermediaries” to hold the cash proceeds and redeploy them to acquire the replacement property in the exchange. We advise our exchangers to immediately sign an exchange agreement with a ‘deep pocket’ bonded QI before closing on the sale of their relinquished property.

  • Irc 1031 Strict Time Constraints

    • 45 Day Rule. The exchanger has 45 days (about 1 and a half months) from the date of sale of the relinquished property to identify potential replacement properties and to deliver a signed form to the QI within that time.
    • 180 Day Rule. The replacement property must be acquired, and the exchange completed within 180 days (about 6 months) after the sale of the exchanged (relinquished) property. The replacement property received must conform substantially to the properties identified within the 45-day period described above.

Reasons to Pursue a 1031 Exchange

  • Defer Taxes.
  • Diversify Real Estate Holdings. Many investors have a large real estate asset representing a significant portion of their equity. They will often seek to lower their risk profile by exchanging out of that property into several smaller properties in diverse sectors and market locations.
  • Increase Cash Flow. Investors discover that their return on equity no longer compares favorably to their return on investment. In other words, they may have been receiving 6% on their original investment, but over time, that translates to maybe 2% on current equity. Accordingly, an exchange will allow them to unleash the captive equity so that the exchanger can increase his cash flow.
  • Active to Passive Management. Many hands-on real estate owners will age out of active management in favor of passive ownership and look to spend their time and energy elsewhere. Yet, they continue to hold their real estate too long because they don’t want to give up 30-40% of their gains to taxes. The 1031 exchange solves that problem. See section on the benefits of DST’s as a turnkey solution for this situation. Click here for more information.
  • Reinvigorate Depreciation Schedule.
  • Estate Planning. (“Swap till you drop.”) Instead of selling property and paying taxes, the investor will complete one or more 1031 exchanges until they die, and their heirs inherit a stepped-up tax basis which permanently erases any capital gains on the inherited property.

Replacement Properties Strategies

An exchanger can acquire replacement properties in any number of ways. Each strategy has its benefits and challenges, and we have experience in blending them together into a hybrid portfolio to accomplish specific objectives. Generally, an exchanger can acquire any type of investment property either (I) as a direct purchase or (ii) through a co-ownership structure.

Direct

(‘fee simple”) You can purchase any kind of real estate through direct purchase, whether it be raw land, a condo, a multi-family development, a shopping center or a hotel, to name only a few. So long as the value of the property equals or exceeds the value of what you relinquished and the debt on the relinquished property is equally replaced on the acquired property, you can qualify any direct purchase real estate for 1031 purposes.


Co-Ownership

A co-ownership structure allows you to acquire a fractional undivided interest in investment real estate by pooling your capital with other investors. These are generally securitized vehicles, and they are available in two forms:

Delaware Statutory Trust (DST)

A Delaware Statutory Trust is a securitized real estate investment vehicle which allows multiple investors to each hold an undivided fractional interest in the holdings of a trust that owns one or more specific investment properties that are significantly larger and of higher quality than they could normally acquire on their own. Generally, the flexibility and turnkey nature of DST makes it the most popular investment strategy for 1031 exchangers today. Click here for extensive discussion on DST’s.

Tenancy-In-Common

More popular prior to the Great Financial Crisis, the Tenancy in common is also a co-ownership structure under which multiple investors (up to 35) pool their funds to own one entire property. Each investor owns an undivided fractional interest in an entire property and participates in a proportionate share of the net income, tax shelters, and growth. Like a DST, the purchase of a TIC interest is treated as a direct interest in real estate, qualifying as “like kind” real estate for 1031 exchange. However, because each TIC investor holds title, there may be the need to sign “carve-outs” related to investor fraud and environmental issues. Generally, these properties are value-add in nature and reserved more for co-invest strategies for large exchanges.

Real Estate Structure: Net Lease vs Gross Lease

These can be acquired by direct purchase or in co-ownership vehicles.

Net Lease

Net Lease Property is a subcategory of fee-simple property and includes all property with a long-term structured net lease. A net lease is a lease that is typically long-term in nature, ranging generally anywhere from 3 to 50 years. Within a net lease arrangement, the tenant agrees to bear the majority of the operating costs associated with the property. Generally, net lease property falls into the following property types: retail, commercial office, medical office, services, food services, financial institutions/banks and gas stations.

  • Common examples: CVS, Advance Auto Parts

Gross Lease

These properties tend to bear more of a relationship between price and intrinsic value of land and improvements. The owner collects rent from the tenant and pays all the expenses for the operation of the property. The owner has much more landlord responsibility than the tenant(s), but also more control.

Master Lease

Most DSTs are structured with a master lease for many legal and administrative reasons, but it also has the benefit of effectively converting a multi-tenant property into a variant of net- leased property.

  • Example: a multi-family development, multi-tenant medical building, etc.
  • DST’s and Master Leases. The DST structure regularly employs a master lease structure to achieve this hybrid benefit of administrative and legal compliance while providing a better alignment of intrinsic value to multi-tenant properties.

Benefits of a Tax Deferred Exchange

EXCHANGE VS. NON-EXCHANGE

Scenario A
Sells Property &
Pays Taxes
Scenario B
Completes 1031
Exchange & Defers Taxes
Purchase Price$500,000$500,000
Depreciation**$300,000$300,000
Adjusted Cost Basis$200,000$200,000
Sale Price$2,000,000$2,000,000
Total Taxable Gain$1,800,000$1,800,000
Federal Long Term Cap
Gain (20% of $1,500,000)***
$300,000$0
State Tax:
(13.3% of $1,500,000)***
$199,500$0
Net Investment Income
Tax (3.8% of $1,800,000)***
$68,400$0
Depreciation Recapture
(25% of $300,000)
$75,000$0
Total Taxes Due$642,900$0
Net Proceeds for Investment $1,357,100$2,000,000

*Each investor should consider his or her current and anticipated investment horizon and income tax bracket when making an investment decision, as the illustration may not reflect these factors.
**This assumes straight-line depreciation
***This assumes the taxpayer is in the highest applicable federal and state tax brackets. If your tax rate is lower, you could have a reduced benefit.