A Guide to 1031 Exchanges
1031 Exchanges can be intimidating to those who are unfamiliar with the process. They are a popular tax deferral strategy for real estate investors involving the sale of one or more assets in exchange for one or more like-kind properties of equal or greater value.
Learn more about 1031 Exchanges here.
What is “Like-Kind?”
To qualify for a 1031 exchange, the properties exchanged must be of “like-kind”, referring to the nature of the property. This lets an investor defer both capital gains tax and depreciation recapture tax upon the sale of property and use the money that has not been taxed, to purchase a like-kind property.
There is a two-pronged test for properties to qualify for IRC §1031 tax-deferral treatment:
- Both the Relinquished and the Replacement Properties must be held by the Exchanger either for investment purposes or for productive use in a trade or business. The Exchanger’s purpose and intent in holding the property is the critical test. The use of the property by other parties to the exchange (Relinquished Property buyer or Replacement Property seller) is irrelevant.
- The Relinquished and the Replacement Properties must also be “like-kind.” The term “like-kind” refers to the nature or character of the property, ignoring differences in grade or quality. For example, unimproved real property is considered like-kind to improved real property, because the lack of improvements is a distinction of grade or quality; the basic real estate nature of both parcels is the same. In essence, all real property in the United States is “like-kind” to all other U.S. real property.
The following are examples of qualifying properties that could be exchanged:
- Raw land or farmland for improved real estate
- Oil & gas royalties for a ranch
- Fee simple interest in real estate for a 30-year leasehold or a Tenant-in-Common interest in real estate
- Residential, Commercial, Industrial, or Retail rental properties for any other real estate
- Rental ski condo for a three-unit apartment building
- Mitigation credits for restoring wetlands for other mitigation credits
Under IRC §1031, the following properties do not qualify for tax-deferred exchange treatment:
- Stock in trade or other property held primarily for sale (i.e. property held by a developer, “flipper” or other dealer)
- Securities or other evidence of indebtedness or interest
- Stocks, bonds, or notes
- Certificates of trust or beneficial interests
- Interests in a partnership
- Choses in action (rights to receive money or other property by judicial proceeding)
- Foreign real property for U.S. real property
- Goodwill of one business for the goodwill of another business
Reset the Depreciation Timeframe of an Asset
Owners who have held onto a property for some time can reset the depreciation on their asset through a 1031 Exchange. As the physical condition degrades over time, expenses reduce the property’s tax liability. This results in the reduction of the property’s tax basis, creating a big difference between it and the sale price. When the property is sold during the exchange process, the depreciation accumulated over the holding period is recaptured and taxed.
Steps to 1031 Exchanges
There are three primary steps to execute an exchange successfully. We’ve detailed the steps below using a Matthews™-facilitated 1031 Exchange as an example.
Step 1: Identify the sale property
The first step of the 1031 Exchange process involves selecting the property to sell. Let’s say a private capital multifamily owner had owned a property for 25 years and grew tired of managing tenants and the everchanging legislative laws making it difficult to be a landlord. The Matthews™ client was motivated to sell their 28-unit, 20,906 square foot apartment property in the Palms Neighborhood of West Los Angeles, CA.
The apartment asset was placed in the Los Angeles Rent Escrow Account Program (REAP), which encourages multifamily owners to maintain the property in a safe and habitable condition. The building had considerable deferred maintenance, was challenging to manage, and did not generate favorable income due to rent control laws.
Step 2: Identify a like-kind property to purchase
The second step involves understanding the purpose and goals of the exchange. Does an owner want less management, better cash-flow, more control over building laws and tenants, more appreciation?
Through the Matthews™ 1031 Exchange Program, the client was presented with two 7-Eleven properties to exchange into:
- The assets located in Florida with long-term corporate leases with an investment-grade tenant and were brand new developments with excellent surrounding demographics.
- A buyer for their client’s California multifamily property was selected and allowed for two 30-day extensions to enable the seller to get their affairs in order for the 7-Eleven purchases.
Step 3: Purchase the replacement property
To conclude the exchange process, the seller must purchase the replacement property. In this scenario, the 1031 Exchange was successfully executed once the seller bought the two 7-Elevens for $7.7 million, which boasted zero management responsibilities and increased their overall cash-on-cash return. The seller’s multifamily property sold for $7.1 million, resulting in limited income loss and a smooth transaction.
Reason and Benefits to 1031 Exchanges
Whether the end goal is to increase cash flow, reduce management responsibility, or reset the depreciation timeframe of an asset, a 1031 Exchange can accomplish several achievements.
Learn more about the benefits of exchanging from multifamily to net lease retail here.
Consolidate or Separate Assets
For investors with a large portfolio, a 1031 Exchange is an excellent strategy to increase the value of a sale by consolidating or separating assets. For example, an apartment owner of a 66 unit building worth $11 million wants to sell and buy 5 triple net lease buildings equaling $20 million. This exchange increases diversity and cashflow while eliminating property management responsibilities. Here, both the buyer and seller can find a mutually beneficial conclusion.
Grow Equity and Holdings
In some cases, a seasoned commercial real estate owner with an expansive portfolio may find it beneficial to undergo a 1031 Exchange. For example, an investor could have a portfolio encompassing eight multifamily properties in California. With the rent control laws in the state, the owner would profit from diversifying their portfolio by investing in another state, whether multifamily or a different asset class. This would allow for a more protected portfolio and increase overall cash flow as the investor could target a state without rent control laws affecting rent increases.
Double-declining balance (DDB) and other accelerated depreciation methods allow for higher depreciation expenses in the early years of an asset’s life and lower expenses as the asset ages. This is contrasted with the straight-line depreciation method, which spreads the cost evenly over the asset’s life. The sum-of-the-years’-digits (SYD) method also allows for accelerated depreciation. To start, combine all the digits of the expected life of the asset. For example, an asset with a five-year life would have a base of the sum-of-the-digits one through five, equaling fifteen. Companies may use accelerated depreciation for tax purposes, as these methods result in a deferment of tax liabilities since income is lower in earlier periods.