1031 Exchange Benefits for Real Estate Investors

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Key Takeaways

  • A 1031 Exchange is a type of commercial real estate transaction that allows real estate investors to defer taxes on the profitable sale of an investment property (the “relinquished property”) as long as they reinvest the sale proceeds into a new property (the “replacement property”).
  • The benefits of a 1031 Exchange go beyond just tax deferral. They include portfolio diversification, depreciation reset, and the ability to trade into higher value properties.
  • To determine if a 1031 Exchange is a suitable fit, it is a best practice for investors to work with their CPA and/or tax attorney to help make the decision.

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For commercial real estate investors, selling a property for a profit can be exciting. But, that excitement often fades when it comes time to pay the tax bill. Fortunately, there is an option that can allow investors to defer capital gains taxes indefinitely in a transaction known as a 1031 Exchange.

This article outlines the benefits of completing a 1031 exchange and whether completing one is worth it for an investor. By the end, readers will have the information needed to determine if a 1031 Exchange is a good fit for their own needs.

At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers and often assist investors with the placement of their 1031 Exchange funds. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.

What is a 1031 Exchange?

A 1031 Exchange is a type of commercial real estate transaction that allows real estate investors to defer taxes on the profitable sale of an investment property (the “relinquished property”) as long as they reinvest the sale proceeds into a new property (the “replacement property”).

7 Benefits of Performing a 1031 Exchange

There are many benefits to successfully completing a 1031 Exchange, but there are seven that are most prevalent.

  1. Tax Deferral
  2. Reset Depreciation
  3. Portfolio Diversification
  4. Trad Into Higher Value Properties
  5. Consolidation
  6. Property Management Relief
  7. Increased Purchasing Power

Benefit #1: Tax Deferral

Clearly, the biggest and most important benefit of a successful 1031 Exchange is the deferral of capital gains taxes. Depending on the taxpayer’s tax bracket and how long the property was held, the capital gains tax rate can be up to 25%. So, in the example above, the gain was $1MM. At 25%, the tax bill here would be $250,000. Deferring this expense is a big win.

Benefit #2: Reset Depreciation

This concept is a bit in the accounting weeds, but it is important. Because real estate is a physical asset whose condition degrades over time, IRS rules allow property owners to expense a certain portion of the property’s value each year. Over time, this depreciation accumulates and, upon sale, investors are required to pay “depreciation recapture” taxes in a typical transaction.

However, in a 1031 Exchange, that depreciation carries over to the new asset and no depreciation recapture must be paid. It is only incurred at the time of a taxable sale.

Benefit #3: Portfolio Diversification

1031 rules make it seem like the “exchange” must be one property for one property. This is not necessarily the case.

1031 Exchange rules allow investors to identify up to three properties and investors could acquire all of them. If they want more than three properties, the 200% rule states investors can identify more than 3 properties as long as their aggregate value does not exceed 200% of the value of the relinquished property. Or, the 95% rule states the investor can identify any number of replacement properties as long as they close on 95% of the value of them.

So, with these rules, a 1031 Exchange can be a great way for investors to diversify their portfolio by type of property, location, or size. For example, an investor could exchange one retail property for an office building, warehouse, and small apartment building as long as the values line up with the rules above.

Benefit #4: Trade Into Higher Value Properties

By deferring property taxes, investors can trade into higher value properties. To illustrate this point, remember the example above? The investors were facing a $250,000 tax bill on their $1MM gain. Instead of paying that to the government, they can take advantage of one of the major tax benefits of a 1031 Exchange – they can use it to buy a more expensive property. Because 1031 Exchanges can be repeated over and over, investors can trade into a series of larger and larger properties.

Benefit #5: Consolidation

An investor could use a 1031 Exchange to diversify their portfolio as described above. Or, they could use it to consolidate their portfolio. In such a scenario, they could exchange many properties for one in an effort to simplify their portfolio or streamline management responsibilities.

Benefit #6: Property Management Relief

Managing a commercial business property can be incredibly time consuming and some investors may want to outsource that responsibility to someone else.

In a 1031 Exchange, they could exchange into a property that has a professional third party manager. Or, they could exchange into a specific property type with a single tenant and a triple net lease. In such a structure, the tenant is responsible for the cost and effort to maintain the property. Either way, investors can get relief from having to manage the property on a day to day basis.

Benefit #7: Increased Purchasing Power

Again, there is no limit to the number of times an investor can complete a 1031 Exchange. Theoretically, they could complete them over and over, deferring capital gains taxes every time. All of this capital that was not used to pay taxes can be used to increase their purchasing power for newer and larger properties.

So, Is a 1031 Exchange Worth It?

Every 1031, tax-deferred exchange transaction is unique and every investor has different goals and needs for their portfolio so it can be difficult to definitively say yes a 1031 Exchange is worth it or, no it isn’t. The true answer is it depends on a number of factors including investor risk tolerance, return expectations, and timeframe in which they may potentially need to realize their profits.

If an investor has a long term outlook, no immediate need for the capital, and a moderate to high risk tolerance, going through the 1031 Exchange process may certainly be worth it.

But, if an investor knows they will need their capital in the short to medium term or if they want to use it to reinvest in a non-real estate venture, then a 1031 Exchange is probably not the best fit for them. It may be worth it to incur the tax liability, pay the taxes as part of filing their next tax return, and move on to the next deal.

Each investor must evaluate their own wants, needs, and investment objectives and determine if a 1031 Exchange is worth it. If there is any doubt, it is a good idea to consult with a CPA and/or a tax attorney to help guide the decision making process.

Investing Through Private Equity Real Estate

A 1031, like kind Exchange, is a complicated transaction and finding suitable exchange properties can be a real challenge. For investors who want to eliminate much of this headache, a compelling option is to work with a private equity commercial real estate investment firm.

Through a structure known as “tenants in common”, private equity firms can take some of the pain out of finding a replacement property while managing cash flow, paying taxes on the property, and ensuring all aspects of the tax code are adhered to.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners. 

If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.

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