Are 1031 Exchanges Worth It & Reasons Not to Do One

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Key Takeaways

  • A 1031 Exchange is a type of real estate transaction that allows individual investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into a new property that is like kind to the one that was sold.
  • For individual investors, a 1031 Exchange offers several potential benefits including tax deferral, portfolio diversification, and estate planning.
  • However, there are also several potential downsides that investors should consider. They include the cost, the limited time frame in which to find a replacement property, and the requirement that these transactions are limited to real property held for investment.
  • Given the nuances of a 1031 Exchange, investors should carefully consider their own personal circumstances in an effort to determine if it is worth it.

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For most commercial real estate investors, one of the primary concerns in a deal is taxes and the concern works both ways. On one hand, a profitable deal can mean a big capital gains tax bill. But, on the other hand, tax code and the IRS treatment of taxable gains can be very favorable for investment property. This is especially true in the case of a 1031 Exchange.

In this article, we are going to describe what a 1031 Exchange is, how they work, their benefits, and potential reasons not to do one – all in an effort to help investors determine if a 1031 Exchange is worth it given their own unique circumstances.

At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As part of our business, we frequently work with real estate investors to help place 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?

To begin the process of deciding if a 1031 Exchange is worth it, it helps to first understand exactly what one is.

A 1031 Exchange, sometimes called a like kind exchange, is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property (the “relinquished property”) as long as they reinvest the sales proceeds into another property that is like kind (the “replacement property”).

To complete this transaction correctly and receive full tax deferral, the Internal Revenue Code (section 1031) lays out a number of rules that investors must follow. The most important include:

  • Investors have 45 days from the sale date of the relinquished property to identify, in writing, their planned replacement property.
  • Investors have 180 days from the sale date of the relinquished property to close on the sale of their identified replacement property.
  • The replacement property must be “like kind” to the relinquished property. In general, most commercial properties are like kind to other commercial properties. So, for example, an investor could not exchange their primary residence for an office building.
  • Investors must reinvest all of the gain from the sale of the replacement property. If they receive any of the sale proceeds, it is considered to be “boot” and it is taxable.
  • The market value of the replacement property must have equal or greater value than that of the relinquished property.

If any of these, or other rules, are violated, the transaction could become taxable. For this reason, real estate investors often work with a team that consists of a CPA, tax law experts (attorneys), and/or Qualified Intermediary to make sure all of the rules are followed.

So, given the rules, the complexity, and time crunch of completing a 1031 Exchange, it is logical for investors to ask…is it worth it?

Reasons Why An Investor Would Want to Do a 1031 Exchange

From the description, it should be clear that the biggest and most obvious reason an investor would want to do a 1031 Exchange is the tax benefits. For investors that are looking at a large gain upon the sale of a property, this reason alone can make it worth it. But, there are a few others that real estate investors also want to take note of:

  • Diversification: Exchange rules do not necessarily require a 1:1 exchange. Provided other rules are followed regarding property value, investors can potentially do a one to many exchange, which could allow them to diversify their real estate portfolio. For example, an investor could exchange one multifamily apartment building for a small retail building and an office property – diversifying their holdings in the process.
  • Estate Planning: Depending on the specifics of the transaction, 1031 Exchange participants can appoint designated heirs who can inherit a property upon death at a stepped up cost basis – saving or deferring taxes in the process.
  • Growth: There is no limit to the number of times an investor can complete a 1031 Exchange. By completing a series of successive deals, investors can allow their capital to grow tax free over a long time frame, which can make a positive contribution to net worth (especially if their tax bracket requires a high capital gains rate).
  • Passive Income: In many 1031 Exchanges, the replacement property is a single tenant, triple net leased property with a high quality credit tenant like Walgreens or CVS. Because the triple-net leased structure requires the tenant to handle all of the property’s maintenance and operations, it can produce passive income for property owners.

Given these benefits, it is easy to understand why the 1031 Exchange is such a popular with investorstransaction type. But, it isn’t perfect.

Reasons An Investor Would Not Want to Do a 1031 Exchange

Aside from the complexity and cost, there are several reasons why real estate investors may want to shy away from a 1031 Exchange.

No Issues Paying Taxes

For some, well capitalized, investors there may not be any issue with paying the tax liability on a profitable sale. For example, a wealthy business owner who invests for fun may not have the time or patience to find a replacement property. So they just pay the taxes and move on to the next transaction.

Investor Has a Loss

If an investor is facing a loss on a property, there is no sense in attempting a 1031 Exchange because there is no gain to defer taxes on. In fact, a loss on sale is something that taxpayers can deduct on their tax return under certain circumstances, providing a reduction in income taxes.

Can’t Find a Replacement Property

Remember, investors have just 45 days from the date of sale to identify their chosen replacement property. This is a short period of time and competition for the best like kind properties can be tough. For whatever reason, if an investor feels that they can’t fulfill this time requirement, a 1031 Exchange may not be the right choice.

Opportunity Zones

A Opportunity Zone is an economically distressed area designated by the Census Bureau. They were created as part of recent legislation which provides tremendous tax breaks for real estate investors who allocate capital to them.

In other words, this option is an alternative to the 1031 Exchange. It has its own unique nuances that may make it a better fit for an investor and a reason not to do a 1031 Exchange.

Non-Real Estate Investment Interest

1031 Exchanges are for investment real estate only. So, if an investor is looking to defer capital gains taxes on another asset like stocks or collectibles, a 1031 Exchange will not do anything to reduce their taxable income.

Cost

Finally, a 1031 Exchange can be an expensive transaction to facilitate. There are attorneys, lenders, Qualified Intermediaries, title agents, and others that charge for their services related to a 1031 Exchange. Some investors may look at the fees relative to the potential cost savings and decide that it isn’t worth it.

So, Is a 1031 Exchange Worth It?

So, given the pros and cons of a 1031 Exchange, it is only logical for investors to ask…is it worth it? Unfortunately, the answer is not as straightforward as many investors would hope. The short answer is, it depends.

For investors with a long term time horizon, a commitment to real estate assets, and a desire to grow their capital in a tax deferred manner, the answer is yes, a 1031 Exchange is probably worth it.

But, if investors are going to need the profits produced by a sale for other, non-real estate ventures, it may not be worth it.

So, the key point is that investors have to take inventory of their own needs and requirements first and then determine if a 1031 Exchange is appropriate for their own unique circumstances.

Investing in a Real Estate Syndication & 1031 Exchanges

For investors who believe a 1031 Exchange is appropriate, there are a number of types of exchanges and methods through which to engage with them. For example, they could choose from a traditional delayed exchange or a less common reverse exchange. In addition, they could choose to complete the transaction on their own or with a third party private equity firm (like FNRP) through a structure known as a syndication.

For individual investors, the major benefit of going the syndication route is that the process of finding a replacement rental property becomes much easier because the firm does the hard work of finding it, financing it, and handling all property management activities once it is purchased.

So, for this reason, many investors find this structure to be beneficial and worth considering when entering into a 1031 Exchange.

Summary of 1031 Exchanges

A 1031 Exchange is a type of real estate transaction that allows individual investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into a new property that is like kind to the one that was sold.

For individual investors, there are several potential benefits to a 1031 Exchange, including tax deferral, portfolio diversification, and estate planning.

However, there are also several potential downsides that investors should consider. They include the cost, the limited time frame in which to find a replacement property, and the requirement that these transactions are limited to real property held for investment.

Given the nuances of a 1031 Exchange, investors should carefully consider their own personal circumstances in an effort to determine if it is worth it.

Interested In Learning More?

First National Realty Partners uses its expertise to find world-class properties and multi-tenanted assets below intrinsic value. 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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