The primary benefit of a 1031 exchange is investors’ ability to move equity on a tax-deferred basis, in order to improve their overall investment position and realize specific goals. The limitations of a 1031 exchange with respect to the identification rules creates anxiety for many, but efforts can be utilized to mitigate the stresses resulting from 1031 deadlines.
Investment in real estate continues to enjoy unique benefits that make it a more attractive vehicle for wealth creation and preservation.
Such advantage unique to real estate investments is the ability to defer capital gains taxes under IRS Section 1031—exchange of real property held for productive use or investment.
In short, a real estate investor may exchange out of the property they wish to sell (“Relinquished Property”), and use the proceeds to reinvest into another income-producing investment (“Replacement Property”) of equal or higher value, all without paying taxes on gains realized from the original sale.
The key benefit realized is that more of the investor’s equity can be applied to another investment that qualifies as “like-kind”. If the investor were to simply cash out, and then use the proceeds after the sale to reinvest, there would be less equity to redeploy, since a significant portion of the gains realized may need to be applied towards their capital gains tax liability and any depreciation recapture.
Example) Investor Ian sells Blackacre for $1M. His tax basis in the property is $100,000. If he were to sell Blackacre and take the cash, the $900K of gain would be subject to capital gains tax at a rate of 20%. Ian could lose $180,000 to capital gains by cashing out. If Ian instead chooses to 1031 exchange out of Blackacre, because the proceeds would be used to purchase an investment property regardless, then he can defer his capital gains liability, and will have an additional $180,000 of equity that can be reinvested.
For Californians, the benefits of a 1031 exchange are even more pronounced. At the Federal level, the capital gains rate is 20% for higher income taxpayers. California does not tax long term capital gains at any lower rate, so the standard rate of 13.3% applies. The effect is that Californians pay the highest capital gains tax across the United States, if they decide to sell their investment property and cash out. The ability to defer tax obligations via IRS Sec. 1031 is an essential tool for Californians to preserve the growth in their equity position, and not have gains realized wiped out due to taxes.
The benefit of a 1031 exchange may make the choice simple enough, but there are important considerations to be sure.
Time—the biggest hurdle to successfully completing a 1031 exchange is meeting the strict deadlines imposed. Once the relinquished property is sold, the exchange client has 45-days to identify the replacement property, and 180-days to close on the replacement property that was identified.
Failure to timely identify or close will invalidate the exchange.
Measures are taken to mitigate the pressures arising from the time limitations imposed under IRS 1031, but it is a consideration that often informs an investor’s ultimate decision to move forward with an exchange or not.
Identification—there are three identification rules, which serves to restrict what you can identify as suitable replacement properties. Whether you choose the 3-Property Rule, 200% Rule, or 95% rule all depends on your particular exchange requirements, but serves as yet another limitation to be aware of when considering an exchange.
Debt, Equity & Boot—so as to defer the entirety of your tax obligation, the 1031 investor must be sure to replace all their equity and any debt relief realized from the sale. For example, if Ian sells Blackacre for $10M, and realizes net proceeds of $7M after paying off a $3M note, then he would need to exchange into a property of equal or higher value, and make sure that either cash is added, or a loan of $3M is taken out against the replacement property.
Any amount that falls short of the debt and equity requirements is considered boot, and will be subject to capital gains and recapture.
Recent Changes to 1031
The Tax Cut and Jobs Act, which was signed into law on December 22, 2017, and took effect on January 1, 2018, served to carve out from the 1031 exchange laws the ability to defer capital gains realized on personal property.
The ability to exchange out of real property remains unchanged; however, the increase to the deficit will require offsetting measures, which has resulted in increased pressure on lawmakers to determine where to best offset the deficit increase resulting from the changes to the corporate tax structure.
The elimination of personal property exchanges may be seen as a harbinger for the potential elimination of real property exchanges.
The nuances of a 1031 exchange can seem incipiently daunting, but there are strategies investors can utilize to mitigate their exposure of risk.
If you have realized significant appreciation in your investment, but feel the asset is producing below-market returns, then a 1031 exchange may be a worthwhile investment strategy.
Real estate is a unique investment vehicle that, in the long term, has always been a major source of wealth creation and preservation. 1031 exchange is a great example of such a tangible benefit proffered by investing in real estate.