Selling Your Investment Property? 1031 Exchange Rules To Consider

I remember the very first 1031 exchange I ever did. I was completely overwhelmed with all the 1031 exchange rules, timelines, and what I could and couldn’t do. 

At the time, I owned a duplex in Washington, DC, which I was house hacking. After years of first house hacking and then operating it as a long-distance rental, the stars aligned, and both sets of tenants moved out around the same time. 

Side note for any DC investors or general real estate nerds: DC’s TOPA law – Tenant Opportunity to Purchase Act – gives tenants the first right of refusal when you sell a property, which can make the sales process long and drawn out. Hence why it was such a boon to have a fully vacant property.

When I first heard about 1031 exchanges, they reminded me of informal swaps I used to do with my friends in elementary school. I give you my sticker book, you give me your stationery set. Win-win!

The concept of a 1031 exchange seemed to offer a similar win-win scenario, which is why they are so popular with savvy real estate investors.

In this article, we will explore what 1031 exchanges are, how they work, the pros and cons of doing a 1031 exchange, why they are so powerful for real estate investors, an example of an exchange, how to use an exchange to invest in real estate syndications, and more.

What is a 1031 Exchange?

At a high level, a 1031 exchange is a transaction in which real estate investors can defer paying capital gains tax on the sale of a real estate investment property by reinvesting the proceeds into another “like-kind” property. This means that the new property must be of the same nature, character, or class as the property being sold. 

Section 1031 of the Internal Revenue Code defines like-kind exchanges as when you “exchange real property used for business or held as an investment solely for other business or investment property that is the same type or ‘like-kind.’

Note that the term “like-kind” refers to the type of property, not the quality or value of the property. This means that you can exchange a commercial property like an apartment building for a residential property, and vice versa.

Most real estate can be like-kind to other real estate. For example, real property improved with a residential rental home is considered like-kind to vacant land. An apartment building is considered like-kind to an office building, etc.

In addition to investments, the Internal Revenue Service also opens up exchanges for business property. So for example, the seller of a business property can defer taxes by investing the proceeds of the sale into a subsequent business property.

When done successfully, a 1031 exchange helps real estate investors defer capital gains taxes, which can help you snowball your wealth at a much faster rate.

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How Does A 1031 Exchange Work?

When considering a 1031 exchange to help defer capital gains tax and snowball your wealth creation, there are a number of 1031 exchange rules real estate investors need to consider to abide by Internal Revenue Service regulations and thus successfully avoid capital gains taxes.

Here’s a high level view of the process:

Step #1 – Sale of the Old Property

The first step in an exchange is to sell the old property (aka, the relinquished property). The proceeds from the sale (exchange funds) are then held by a qualified intermediary, who is responsible for ensuring that the exchange meets all the requirements of the IRS.

Step #2 – Identification of Replacement Property or Properties

Once the relinquished property is sold, real estate investors have 45 days to identify potential replacement properties. The IRS allows you to identify up to three properties as potential replacements, but there are some restrictions on how they can be identified.

For example, replacement properties must be of equal or greater value than the property you’re selling. This “equal or greater value” rule means that you must reinvest all of the proceeds from the sale of the original property into the replacement property or properties.

Step #3 – Purchase of Replacement Property 

You have 180 days from the sale of the old property to complete the purchase of the replacement property. The purchase must be made using the funds held by the qualified intermediary.

Step #4 – Completion of the Exchange

Once the replacement property has been purchased, the qualified intermediary will transfer the funds from the sale of the old property to the seller of the replacement property. The exchange is now complete, and you have successfully deferred paying taxes on the sale of the old property. Woohoo!

Want to dig deeper? Listen into our podcast episode with Dave Foster of The 1031 Investor to hear him share more details about the process. (P.S. Dave and his team did my exchange, and they were wonderful to work with.)

Real estate professionals: For more info about tax advantages, check out this article on Real Estate Professional Status (REPS)

Pros And Cons Of Doing A 1031 Exchange

If you’re considering doing an exchange but are not sure whether it’s right for you, let’s take some time to consider the pros and cons.

1031 Exchange Pros

First, there are several advantages to doing an exchange, including:

1. Capital Gains Tax Deferral

The main advantage of an exchange is the ability to defer your capital gains tax liabilities on the sale of the old property. This can result in significant savings, as you can reinvest the proceeds from the sale into a new property without paying capital gains taxes.

2. Portfolio Growth

Because capital gains tax on the relinquished property is deferred, you can use the full amount of the sale proceeds to purchase a new property. This allows you to grow your portfolio and expand your holdings at a significantly faster pace than if you were to sell outright, pay taxes, and then invest in a new property.

3. Diversification

A 1031 exchange allows you to diversify your portfolio by exchanging one type of property for another. This can help mitigate risk and create a more balanced portfolio.

For example, if all of your investments are in a single market, you can use a 1031 exchange to diversify into other markets and thus spread out your risk.

1031 Exchange Cons

However, there are also some disadvantages to doing a 1031 exchange, including:

1. Limited Options

The like-kind requirement can limit the options available to investors when selecting replacement properties. Investors may have to settle for a property that is not their preferred type, location, market value, or quality due to the requirements of the 1031 exchange.

As a side note, if you’re considering investing in a REIT (real estate investment trust), you also cannot directly 1031 exchange into REIT investments or real estate syndications (more on that in a bit).

2. Complex Process

The process of completing a 1031 exchange can be complex and time-consuming, and there is a good amount of terminology to learn, including delayed exchanges, reverse exchange, qualified intermediary, and more.

Real estate investors must comply with IRS rules and regulations, which can be challenging for those who are not familiar with the process. If you fail to follow the 1031 exchange rules, you may trigger capital gains tax.

3. Risk of Disqualification

If the exchange is not completed properly or does not meet the IRS requirements, the investor may be subject to taxes, penalties, and interest. Even a small mistake in the process can disqualify the exchange and result in taxes due.

4. Depreciation Recapture

If the investor sells the replacement property at a later date and does not complete another exchange, they may be subject to depreciation recapture. This means that any depreciation that was deferred during the exchange will now be subject to taxes.

5. Timing Risk

The timing of an exchange can be risky. If the market is not favorable at the time of the exchange, the investor may have to settle for a lower quality property or pay more for a replacement property.

Note that you can work with a qualified intermediary to consider a either a reverse exchange or a delayed exchange. A delayed exchange offers you the flexibility of up to a maximum of 180 days to purchase a replacement property. Consult with a qualified intermediary for full details.

It is important for you to carefully consider the pros and cons of a 1031 exchange and to consult with professionals, such as a tax advisor or qualified intermediary, before proceeding with an exchange.

Food for thought: In addition to the 1031, you may also have heard of a Deferred Sales Trust (DST), which is another way you can defer your capital gains taxes, via an installment sale. 

When thinking of Deferred Sales Trust pros and cons, the main upside is that you can defer your taxes without needing to follow the strict 1031 rules, but the downside is that you won’t get your money from the sale immediately, and you may have to structure the sale to get small amounts of money over a long period of time. 

 

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1031 Exchange Example

Let’s take a look at a simple example of an exchange in action, to give you a better idea of whether or not it’s right for you and your investing goals.

Let’s say that Jane owns a rental property in San Francisco that she purchased for $500,000 several years ago. Over time, the property has appreciated in value, generates reasonable monthly rental income, and has a current fair market value of $1 million. Jane is interested in selling the property to cash out her equity and invest in a larger rental property elsewhere.

If Jane were to sell the property outright, she would owe capital gains taxes on the appreciated value of the property, which would significantly reduce the amount of money she would have to reinvest in a new property.

Instead of selling the property outright, Jane decides to do a 1031 exchange. She works with a qualified intermediary to identify a replacement property worth at least as much as the value of her current property.

After identifying a replacement property, Jane sells her current property for $1 million and uses the proceeds from the relinquished property to purchase the replacement property for $1 million. Because she completed the exchange, Jane is able to defer the capital gains taxes she would have owed on the sale of her original property.

Side note: In this basic example, we’re having Jane exchange one property for one property. However, you can also exchange one property for multiple properties, which is exactly what I did.

In this way, Jane is able to reinvest the full value of her original property into a new like-kind property without incurring any immediate taxes. 

If Jane decides to sell the replacement property at a later date, she may be subject to capital gains taxes on the full value of both properties, but she can continue to defer those taxes by using the proceeds from the sale of the replacement property to purchase another property through a 1031 exchange.

Many successful investors deferred capital gain taxes in exactly this way, allowing them to snowball their wealth creation exponentially.

Fun fact: You can also exchange personal property, like machinery, equipment, collectibles, vehicles, boats, aircraft, artwork, patents, and other intellectual property. However, real estate investment properties are not considered “like-kind” to personal property.

Can You Use A 1031 Exchange To Invest In A Real Estate Syndication?

This is probably one of the most frequently asked questions we get. Oftentimes, we hear from investors who have rental properties they’ve owned for several years, but either due to life circumstances, changes in local regulations, or just wanting to be done with the hassles of being a landlord, they’re ready to sell and reinvest passively into a real estate syndication.

Due to the large gains at sale and the accumulated capital gains taxes, the ideal for many investors would be to do a 1031 exchange, passive investing those returns into a syndication.

Unfortunately, there’s not a simple and direct way to 1031 into a syndication or 1031 into REIT (real estate investment trust) investments. 

The reason for that is because, based on the rules of a 1031 exchange, the 1031 exchange procedure requires that title must be held in the same name for both the relinquished property and the replacement property.

In other words, if your current property is held by Best Investments, LLC, any replacement properties you purchase via a 1031 exchange must be purchased under that same name. 

However, when you invest in a syndication, you are essentially investing in shares of a new LLC (formed when the syndication is put together) that then buys the property. Thus, you can’t directly exchange your property for shares in the new LLC.

That being said, there are certain real estate syndications that are set up as a DST (Delaware Statutory Trust), which do allow a direct 1031 exchange. Often, because of the additional fees and hurdles, DSTs tend to offer lower overall returns as compared with traditional syndications.

But! You know what they say. It’s never about resources; it’s about resourcefulness. Even though you can’t do a traditional 1031 exchange from a rental property into a syndication, you do have a couple of options.

Option #1 – Sell Outright, Then Invest In A Syndication

As you know, one of the primary reasons to consider a 1031 exchange is the tax benefits. In the example with Jane above, where she originally bought the property for $500k and is now selling for $1 million, she would be subject to a boatload of taxes if she were to sell outright.

However, if she were to sell outright and then within that same calendar year, she invested the sales proceeds into a syndication with high year 1 depreciation, she could reap tax benefits that are equivalent to doing a 1031 exchange.

This is exactly what I did a few years ago when I sold a different duplex I held, also in Washington, DC. Rather than 1031 into multiple rental properties (and thus incur more headaches), this time I chose to sell outright and then work with my CPA to determine the potential tax implications and how much I would need to invest into a syndication, and at what level of depreciation, to offset those taxes.

There was definitely some math involved, but it worked like a charm. Best of all, I wasn’t confined to the strict rules and timelines of a 1031 exchange. 

If this is a path you’re considering, we highly recommend you consult your CPA so you have a strong understanding of your unique situation and the year 1 depreciation you would need in a new investment.

Also, be sure to look into whether you’re an accredited or non-accredited investor, so you can be sure to find the right syndication investments for you.

Side note: Keep in mind that, based on the current laws, the amount of bonus depreciation you can take is in the process of decreasing every year – 100% in 2022, 80% in 2023, 60% in 2024, and so on. What this means is that, if you’re considering this path, the sooner you make a move, the better!

Related: What Every Passive Investor Should Know About Taxes

Option #2 – 1031 Into A Syndication Via A TIC

If you did want to stick to the confines of a 1031 exchange, there is another option to consider, though not every syndication group will allow you to invest via this path.

To use a 1031 exchange to invest in, say, an apartment building syndication, you can do so via a TIC (tenancy-in-common) ownership structure. This means that you would own a fractional interest in the property and thus are entitled to a share of the income and expenses. 

Note that you would not be an LP (limited partner) investor, as you would come in alongside the LPs, as a TIC. 

Just as with a typical 1031 exchange, the syndication must be identified as a replacement property within the 45-day identification period. You must identify the syndication specifically, and cannot simply leave it open-ended or do a real estate trust (REIT) 1031 exchange. 

Your fractional ownership interest in the syndication must be equal to or greater than the value of the investment property that was sold. This means that the investor must ensure that the value of their interest in the syndication is equal to or greater than the value of the investment property that was sold, including any debt or other liabilities.

If you are considering using a 1031 exchange to invest in a real estate syndication, you should work with a qualified intermediary and consult with your tax advisor to ensure that you fully understand the requirements and implications of the transaction. You should also carefully evaluate the potential syndication and its investment structure to ensure that it aligns with your investment goals and objectives.

Next Steps

If you are tired of the hassles of being a landlord and are considering selling your rental property so you can invest passively in a real estate syndication, we invite you to reach out to our team to learn more about your options when it comes to 1031 exchange, REIT investments, real estate syndications, and more.

Remember – even though the exchange process might seem intimidating, the Internal Revenue Service put this tax code out for a reason. They WANT you to succeed at this.

Further, through selling your property and investing in real estate syndications, you can diversify your portfolio and take advantage of the cash flow, equity, appreciation, and tax benefits – which can be just as good or even better than what you might achieve via a 1031 exchange. (As always, consult your CPA for full details on your unique situation.)

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