1031 Exchanges are a popular tax deferral strategy for real estate investors, wherein a commercial property owner sells one or more of their assets in exchange for one or more like-kind (investment real estate) properties of equal or greater value and defers capital gains taxes. Commercial real estate owners have the opportunity to capture new wealth and preserve existing equity by exchanging into bigger or more expensive properties depending on the investment goals. Additionally, investors can maintain the step-up basis by exchanging into a property that has more favorable lease structures, requires less management responsibility, or produces passive income. In this article, Matthews™ will review the pros and cons of 1031 Exchanges.
Beyond the capital gains tax deferral that a 1031 Exchange can accomplish, there are several other reasons why astute investors favor the investment strategy. The primary advantage of a 1031 Exchange is the ability to defer capital gains taxes. Through the “like-kind” clause of a 1031 Exchange, the up-leg property must be of the same nature (meaning it must be an investment real estate asset). Like-kind is often misinterpreted as meaning the up-leg property must be the same asset class (multifamily, industrial, net lease retail, office, etc.) as the down-leg property; however, that is not the case. Below are more advantages to executing a 1031 Exchange.
Off-Load Management Responsibility
Certain assets require more maintenance costs, property taxes, insurance, and employees. Investors can choose to depart from a time-consuming property by exchanging into a less time-intensive asset and produce passive income. For example, if a multifamily owner finds the properties’ responsibilities too overwhelming, exchanging into a net lease retail asset that requires minimal involvement might be more suitable.
Consolidate or Separate Assets
Through a 1031 Exchange, investors can enter new markets in the U.S. with high growth potential. If an owner has an investment property in a highly appreciated market, like California, they could exchange into multiple properties in affordable states to optimize cash flow. Another opportunity available for investors is investing in income-tax-free states, preventing double taxation (keep in mind that some states require investors to pay state capital gains tax). RESET
1031 Exchanges give the option to “reset” the depreciation schedule to a higher value by purchasing a property of greater value. This strategy allows for a considerable tax benefit, providing an investor with a tool to increase their after-tax cash flow. This tool is especially useful to those who have fully depreciated their investment.
Grow Equity and Holdings
1031 Exchanges are a great way to diversify a portfolio by exchanging into a different asset type while generating more returns. The tax deferral strategy allows investors to recapture and realign their investment goals as higher-value properties, which are more accessible by exchanging one property for another or into multiple properties. This lowers the investor’s risk profile and exposure to disruption by owning properties in various markets.
When the real estate owner passes, the heirs receive a step-up in cost basis equal to the fair market value at the time of death. The heirs will not inherit the depreciation recapture or capital gains tax liabilities on the real estate. An owner can take advantage of exchanging into a larger asset while they are still alive and eliminate the built-in gain when passed through heirs.
Although avoiding the capital gain taxes is attractive in itself, there are still some considerations to weigh to help decide if a 1031 Exchange is the right investment strategy.
Although a 1031 Exchange is advertised as a tax deferral strategy, the tax on capital gains still needs to be paid. While most states follow the federal code, it’s important to understand the exchange property’s state taxes. For example, Texas is an income tax-free state but makes up for it with a high property tax of 1.8 percent.
Taxed on the Boot
If a replacement property is identified but worth less than the property being sold (less ordinary transaction expenses), capital gains taxes must be paid, and accumulated depreciation is recaptured through the difference in the property’s prices, which is referred to as the “boot.”
Difficulty Identifying Like-Kind Properties
Finding a property that meets an investor’s goals can be difficult, especially in a 45-day timeframe. If a replacement property is not identified, the investor will have to front the taxes on the total gain from the first sale. It’s imperative to work with a qualified broker with a reputable firm to avoid this situation.
Whether a seasoned or first-time investor, both will need professional advisors to navigate the fees and regulations. Further, investors need to hire a Qualified Intermediary (QI) to facilitate
It’s important to note that the 1031 tax code restricts investors from exchanging into a value-add property with the intent to sell at a profit in a quick timeframe. Though the IRS does not state a specific time a property must be held, holding onto the property for less than two years can trigger a “dealer status,” something investors should be cautious of. However, there is no limit to how many 1031 Exchanges someone can execute.
While the reasoning behind an investor’s exchange may vary, the overall goal is usually the same, such as increasing cash flow, less management responsibility, or more favorable lease structures. Below are common exchange scenarios, often involving exchanging out of one asset type into another. Though, it is not unusual for owners to exchange into the same asset class.
Multifamily to Triple Net Lease
Multifamily owners who exchange into triple net lease retail assets are often looking to get out of the management aspect of owning an apartment building. Rather than dealing with several renters, or tenants, the investor can prioritize one tenant through a retail asset. Further, a multifamily property often experiences a high-tenant turnover, while retail properties boast long-term leases, consistent revenue, and security.
Multifamily to Industrial
After seeing the value in a warehouse space, a multifamily owner can exchange it for an industrial property. Comparatively, there are fewer management responsibilities and maintenance needed on the building. Again, multifamily owners would be looking to exchange from an asset with more tenants to less tenants.
Multifamily to Multifamily
In this scenario, the multifamily owner is likely exchanging into another multifamily asset for reasons including moving out of rent control states, seeking more attractive cap rates, increasing cashflow through a better-performing property, or states where the population is moving. More recently, multifamily investors in California and New York have been migrating to states like Arizona, Texas, Florida, and Georgia.
Medical Office Building (MOB) to Multifamily
To capitalize on the ongoing work-from-home trend, a MOB owner can exchange into a multifamily asset. Tenants in MOBs traditionally sign longer leases than multifamily renters, who often sign a one-year lease with annual renewals. Additionally, medical office leases state predetermined rent increases with the opportunity to negotiate, whereas multifamily tenants are less likely to negotiate with landlords.
Industrial to Industrial
An industrial owner who has held onto their property long-term may find it has increased in value. To capitalize on this, the owner can exchange into another industrial property to either start a new endeavor with a tenant in place or prepare for retirement.
The Potential Impact of the American Families Plan
The American Families Plan is the second part of President Joe Biden’s ten-year initiative, the counterpart to a $2.3 trillion infrastructure and jobs package called the American Jobs Plan. The $1.8 trillion economic proposal will be paid for by tax hikes on capital gains and individual income. Though it is currently speculative and will be a challenge to pass in Congress, the proposed tax increases are cause for concern in the commercial real estate industry.
This plan affects or eliminates some critical commercial real estate policies, such as
- Ending “special real estate tax break” for gains exceeding $500,000
- Doubling capital gains to 39.6% on assets held longer than a year or investors making over $1 million annually
- Raising personal income tax to 39.6% for those making more than $400,000
- Increasing the corporate tax rate from 21% to 28%
- Eliminating stepped-up basis for gains of $1 million or more
A 1031 Exchange is an excellent option for investors looking to increase cash flow through their real estate, eliminate management responsibilities, expand portfolios, or recycle capital into more fruitful opportunities. While there are several advantages, it’s essential to remember that 1031 Exchanges only defer capital gains taxes, and they will still need to be paid. Further, Biden’s proposed American Families Plan may play a role in the future of 1031 Exchanges, so it’s necessary to meet with a qualified professional who can provide guidance through the process.