When it’s time to move on from a real estate investment, securing your next property through a 1031 Exchange may be the best option. Taxes can be deferred, portfolios diversified, and long-term goals realigned.
Before finalizing the decision, there are six main items to consider to ensure successfully completing the 1031 Exchange.
In a 1031 Exchange, one investment property is sold and the proceeds are reinvested in a like-kind real estate property, or properties, of equal or greater value. Simple enough, but complicated decisions must be made about taxes, replacement properties, intermediaries, and objectives.
Taxes are often front and center in a 1031 Exchange
Deferring taxes are often a primary 1031 Exchange consideration. Instead of a tax liability from a traditional sale that can run as high as 40% of the profits, capital gains taxes, depreciation recapture taxes, and potential state taxes are deferred. These taxes will come due whenever the investment properties sell in a non-1031 Exchange, but at this moment, that money can help secure a potentially more desirable replacement property.
Deadlines to complete the 1031 Exchange
Ideally, the decision to pursue a 1031 Exchange is made before relinquishing the initial property because once the original property sells, the clock starts ticking. The investor has 45 days to identify replacement properties and 180 days to close on the new investment. There are generally no exceptions and if either deadline passes, the 1031 Exchange cannot be completed.
Rules to follow in selecting replacement properties
It’s possible, and often advisable, to identify more than one replacement property during the permitted 45-day exchange period. Investors can select up to three replacement properties of any value (aka “The Three Property Rule”). Alternatively, it’s possible to select more than three properties if the combined value doesn’t exceed 200% of the gross sale price of the relinquished property (aka “The 200% Rule”). The 200% is more commonly used when selecting DSTs since the lower minimum investments for DSTs e.g., $50K to $100K allow investors greater flexibility to invest in diversified portfolios of properties that may mitigate the risks of putting too many eggs into too few baskets.
Replacement property eligibility
The 1031 Exchange statute dictates that the replacement property must be a like-kind investment. This broad description includes many different types of investment properties. It could be a commercial building, a single-family home, land, or beneficial interests in a Delaware Statutory Trust (DST). The main qualification for eligibility is that the replacement property must be a real estate business investment. It cannot be personal property such as a primary residence or second home. Care must also be taken to annually report income received from the replacement property on appropriate tax forms e.g., Schedule E.
Choose your Qualified Intermediary wisely
All 1031 Exchanges must include a Qualified Intermediary (QI) who facilitates the exchange. Optimally, you will select your QI before selling your initial property because you can't be your own QI and you can't use your real estate agent, accountant, attorney, or an employee. The QI holds the sale proceeds in escrow and documents the replacement properties identified. If you are considering DST investments, we recommend that you hire a QI who has substantial experience in concluding successful exchanges involving DSTs.
Focus on your long-term and short-term goals
Do you want to manage a single property or expand your portfolio to multiple properties? Do you want to be responsible for property management or are you looking to offload that responsibility? Are you looking to diversify your portfolio? Do you want to convert the appreciated equity in your current rental properties into assets that can be more easily managed by your heirs? A 1031 Exchange is a chance to realign investment and personal goals and find an investment that better fits your current objectives.
If you are looking to diversify your portfolio or want to get out of the day-to-day property management business, you might want to consider a DST. Instead of owning property, the investor owns beneficial interests in a trust. A DST can benefit those looking for a longer investment time horizon as it’s an illiquid investment that is meant to last five-to-10 years. Keep in mind that all real estate, including DSTs have some amount of risk.
For investors who have worked hard over many years to build a portfolio of rental properties, we often encourage them to take “take some money off the table” and enjoy some of their wealth. Take a bucket list trip – or buy something that they have putting off. Sure, you will need to pay taxes on the funds that you take out of the exchange, but as they say, you can’t take it with you, and you should consider having some reward for all the years of hard work.
Next steps in completing a 1031 Exchange
A 1031 Exchange can yield multiple benefits such as deferring taxes, diversifying an investment portfolio, and realigning goals, but whichever decision you make, it’s always best to consult a financial professional or tax specialist and develop more than one option.
For more information on 1031 Exchange tax deferral strategies, please contact First Guardian Group at 866-398-1031 or info@FirstGuardianGroup.com. You can also schedule a one-on-one consultation with Paul here.
Disclosure: DSTs, like all real estate, have risks, including illiquidity, potential for loss of property value, costs and expenses that could offset the benefits associated with tax deferral, and reduction or elimination of monthly cash flow.
Disclaimer: There is no guarantee that any strategy will be successful or achieve investment objectives. All real estate investments have the potential to lose value during the life of the investments. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please be aware that this material cannot and does not replace the Memorandum and is qualified in its entirety by the Memorandum.
This material is not intended as tax or legal advice so please do speak with your attorney and CPA prior to considering an investment. This material contains information that has been obtained from sources believed to be reliable. However, FGG1031, First Guardian Group, LightPath Capital, Inc., and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) and 1031 Exchange properties. These include, but are not limited to, tenant vacancies, declining market values, potential loss of entire investment principal.
Past performance is not a guarantee of future results: potential cash flow, potential returns, and potential appreciation are not guaranteed in any way and adverse tax consequences can take effect. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All financed real estate investments have a potential for foreclosure. Delaware Statutory Trust (DST) investments are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits.
IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, you should consult your tax and legal professional for details regarding your situation.