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The term 1031 Exchange is defined under section 1031 of the IRS Code. To put it simply, this strategy allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long as another “like-kind property” is purchased with the profit gained by the sale of the first property.
The IRS Outlines several rules that must be followed for a transaction to qualify for tax deferral through a 1031 exchange. Rules address which types of real estate can be utilized for an exchange and how proceeds from the sale of the relinquished property must be handled throughout the exchange, how and when replacement property must be identified, and required timelines for closing on the replacement property.
The investment properties exchanged must be “like kind” meaning they are the same in nature and character.
The value of the replacement property must be equal to or greater than the value of the relinquished property to obtain a full deferral.
The title of ownership on the replacement property must be the same as on the relinquished property.
According to IRS Section 1031, both the relinquished and the replacement properties must be held for investment purposes, and they must be “like-kind” properties. Property held for investment purposes can include a multitude of real estate types, but most are rental properties or commercial real estate. Personal residences and vacation homes that are not utilized primarily as rentals do not qualify for a 1031 exchange. “Like-kind” simply refers to the fact that investment real estate must be exchanged for investment real estate.
In other words, investment real estate cannot be exchanged for stock, debt, or other investments in a 1031 exchange. Also, a 1031 exchange applies only to real estate located in the United States.
Allows an investor to identify up to three potential replacement properties and close on any or all of them to complete the exchange.
Allows an investor to identify an unlimited number of properties, but the investor must purchase 95% of the aggregate fair market value of all of the properties identified.
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The most important deadlines for a 1031 exchange are the identification and closing dates. Weekends and holidays are included in the deadlines. Investors must adhere strictly to the timeline in order to complete a successful 1031 exchange.
• 45-Day Rule: Within 45 days of the close of escrow for the relinquished property, an investor must identify any replacement property that will be purchased to complete the exchange.
• 180-Day Rule: Within 180 days of the close of escrow for the relinquished property, an investor must close on the purchase of the replacement property identified to complete the exchange.
Exchanger sells relinquished property any proceeds are escrowed with a Qualified Intermediary.
Identify up to three replacement properties within 45 days of the close of escrow
The purchase of the replacement property(ies) must be completed within 180 days
Exchanger Sells Relinquished Property
Identify Replacement Properties
Purchase Replacement Properties
Exchanger sells relinquished property any proceeds are escrowed with a Qualified Intermediary.
Identify up to three replacement properties within 45 days of the close of escrow
The purchase of the replacement property(ies) must be completed within 180 days
Every year, hundreds of thousands of investors subject themselves to the anxiety that comes with the challenge of completing a 1031 exchange. IRS imposed deadlines and the challenge of finding a “Goldilocks” property can be a daunting to an investor. That anxiety, however, is avoidable by working with a trusted advisor and planning ahead.
Limited Timeframe To Identify Replacement Properties
High·Risk Of Unsuccessful Close
Can Be Difficult To Diversify Portfolio
No Guarantee That Replacement Can Equal Success
Investor Could Be Limited To Local Properties
At its core, a 1031 exchange is designed to accomplish one simple goal: to mitigate or avoid taxes. Owners and investors often turn to 1031 exchanges to carry out a variety of business strategies. An investor may trade a single family property for triple net income properties for a better return. In a more complex deal, an exchange can be part of an exit strategy for a partnership. Working with a trusted Advisor can help guide you through the process of a successful 1031 exchange.
Highly Appreciated Trapped Equity
Restart The Depreciation Schedule
Challenging Financial Objects
(Growth Vs. Income)
Aging Properties = More Upkeep,
Lower Quality Tenants
Capital Gains Are Significant!
Capital gains and depreciation recapture taxes can be deferred indefinitely through the use of 1031 exchanges. This tax burden can be avoided permanently through a “step up in basis,” whereby heirs inherit property and realize a basis adjustment to the current market value as of the date at death or alternate valuation date. Heirs realize gains and taxes on sales only on those gains above this new, potentially higher valuation. Additionally, the heirs receive a new depreciation schedule, which can be utilized to shelter the property’s income from taxes.
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Since DSTs are securities, most real estate professionals do not provide this option to their clients because they are not licensed, may be uneducated on the matter or simply not aware of the concept. Therefore, many investors make their decisions not even knowing this option exists. A knowledgeable broker or investment advisor in the area of DSTs is generally better equipped to discuss and potentially assist in these investment options. For the right investor DSTs can be the far superior option.
DSTs were created specifically for those seeking to perform a 1031 exchange, but also in mind for investors preferring to place their funds into stable, income producing properties. FINRA has enforced certain restrictions on the sponsors who create and manage the DST in order to ensure this.
Low Leverage: Most employ leverage of about 40%-50%, with a maximum of 80% LTV
Fully Stabilized: The property must have at least 90% occupancy before it comes out to investors
Conservative Investment Strategy: Sponsors cannot employ high-speculation tactics like ground-up developments or deep value-adds
Real Estate is an essential asset class for investors and has the potential to offer stable income returns, protection against inflation and proper diversification in a balanced portfolio. An efficient real estate allocation should include varied sectors, geographical diversity and different investment strategies.
ASSET CLASSES
COMMONALITIES:
Strong economic anchor, low correlation to economy
*Always want to make sure the Sponsor has a long, successful track record, industry standard fee structure and experienced leadership
ASSET CLASSES
COMMONALITIES:
Weak economic anchor, direct correlation to economy
One of the single greatest advantages of utilizing DSTs in a 1031 exchange is the power to diversify your investment. In the example below, we took an investor exchanging their single-family rental into multiple DSTs. They are still taking on similar real estate risk, but are now more diversified in several aspects: Number of properties & tenants, multiple geographic locations and a balanced mix of asset classes and strategies.
The IRS allows individuals to bypass the capital gains tax on the sale of real estate if they invest the proceeds into a “like kind” investment, effectively creating a exit strategy for assets that are highly appreciated. However, actually pulling this off is no easy feat and requires a considerable amount of timing and knowledge. Affluent families have been using this tactic for decades as a means to avoid capital gains and minimize the tax impact of their real estate holdings to their heirs. Like our hypothetical outcome as expressed below, we can show you how to take advantage of this rule, and provide turnkey 1031 exchange solutions that take away the complexity typically associated with this type of transaction.
The hypothetical scenarios provided herein are meant only to demonstrate mathematical principals. There can be no guarantee of performance or that any investment will achieve its stated objectives.
John & Cindy, a married couple in their 60’s, owned several rental properties in Southern California that had done quite well. Even though they were making a good income, one property in particular was aging and needed some work in order to attract the quality tenant that John & Cindy were accustomed to. Now a decision had to be made; either spend a considerable amount to make the improvements, or sell the property and pay massive capital gains taxes. John was aware of the concept of a 1031 exchange, but the complexities and timing issues were preventing him from taking full advantage of it.
By utilizing a 1031 exchange we were able to reinvest the proceeds from the sale of their property into three different DSTs. Each of these properties were institutional quality assets utilizing different strategies located in multiple states. Furthermore, their was no 1031 exchange risk or an interruption in rental income for John & Cindy.
John & Cindy were very satisfied with the fact that they were now much more diversified investors and not having to rely on just a handful on tenants. In addition, their after-tax net income from the property increased from approximately $45,000 annually to over $60,000 annually. John & Cindy also loved that they no longer had to manage the day to day issues that came with the property and had more time to enjoy their retirement together.
Besides his closing costs, the advice and DST execution was free of charge to John & Cindy.
For a Comprehensive Overview on 1031 Exchanges and DSTs Download Breakwater Capital’s Ebook
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Real Estate / 1031 Risk Disclosure: • There is no guarantee that any strategy will be successful or achieve investment objectives; Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments; Change of tax status – 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; Potential for foreclosure – All financed real estate investments have potential for foreclosure; • Illiquidity –These assets are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments; Reduction or Elimination of Monthly Cash Flow Distributions – 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; Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits. Stated tax benefits – Any stated tax benefits are not guaranteed and are subject to changes in the tax code. Speak to your tax professional prior to investing.
All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future performance. There can be no guarantee that any investment or strategy will achieve its stated objectives. Speak to your tax and/or financial professional prior to investing. Securities and advisory services through Emerson Equity LLC, member FINRA and SIPC and a registered investment adviser. Emerson is not affiliated with any other entity identified herein.
