An Explanation of 1031 Exchanges

Here’s the good news: The real estate your about-to-retire client owns has increased in value significantly since they bought it. The not-as-good news: If they were to sell that property, they’d probably face a sizable tax bill on the proceeds of that sale. That could reduce the value of the asset just when they’re focused on preservation or harvesting.

The much better news: With certain strategies, it’s possible to minimize that tax bill, or even reduce it to zero. One approach worth considering is a 1031 exchange, which allows a real estate investor to defer taxes on the sale of a property if they use the proceeds to purchase another like-kind property of equal or greater value.

Rob Johnson, head of wealth management for Realized, suggests thinking of a 1031 exchange as a tool to keep more of an investor’s real estate wealth working for them. “It’s a tax-deferred exchange, so you’re not subjecting that valuation to taxes,” he says. “The goal is to maintain more of the capital to continue seeking growth in the asset’s value.”

Making sure your clients understand how 1031 exchanges work—and whether they might benefit from them—can give them more tools to make informed decisions about their financial future.

The basics of a 1031 exchange

The 1031 exchange takes its name from Section 1031 of the Internal Revenue Code, which states that tax liabilities can be deferred when one property is exchanged for a like-kind property of equal or greater value. Here’s how they typically work: First, the real estate investor sells a property and parks the proceeds with a qualified intermediary (QI), who holds those assets in a trust or an escrow account. Once a like-kind property is found, the investor purchases the property using the funds held with the QI. If done properly, this exchange of properties produces a tax deferral on the capital gains acquired from the sale of the relinquished (original) property.

A transaction has to meet certain criteria in order to qualify as a 1031 exchange. This criteria can present challenges for the investor and their advisor so it’s important to understand them before deciding whether to pursue an exchange.

Timing. Once the property has been sold, the IRS mandates a 45-day deadline to identify a like-kind property and a 180-day deadline to buy that property. Also, the QI must be involved prior to the sale of the property to set up the 1031 exchange. “You have to line up a qualified intermediary at least three weeks minimum before that close date,” Johnson says. “And it’s important that the QI is a well-established firm with a good track record in the space.”

Qualifying as like-kind. The property being sold and the one being purchase must both be business or investment properties held in the United States. Neither can be a personal residence. The acquired property also must be of equal or greater value to the sold property—and all the proceeds from the sale of the original property must be used to buy it. The acquired property cannot come from a related party. Note that REITs, partnerships and LLCs do not qualify as like-kind properties.

Managing debt. It’s important to consider any debt on the relinquished property before making the exchange. If, for example, a client sells a property for $200,000, they have to replace it with a property worth at least $200,000 to satisfy the terms of a 1031 exchange. If closing costs and a large mortgage balance leave them with only $100,000 in proceeds from the sale, then they’ll have to either invest at least another $100,000 in the new property, or take out another mortgage on the acquired property to meet the “equal or greater value” criterion.

Using a 1031 exchange to change ownership structures

An additional provision of 1031 exchanges makes them particularly powerful: The relinquished property and the acquired property do not need to have the same ownership structure. For example, a client can use a 1031 exchange to relinquish a property they directly own for shares in a Delaware Statutory Trust (DST) or a tenant-in-common (TIC) arrangement. A DST allows a client to hold fractional ownership of commercial real estate, which can help clients build a more diversified real estate portfolio. A TIC, on the other hand, allows a client to share direct ownership of a single property with other investors.

If your client is using a 1031 exchange for this kind of transition, it pays to have an experienced partner on hand who can help make sense of all the options for applying this strategy. Ideally, you and your client will work with a partner who can also facilitate the exchange, perform due diligence on the potential replacement properties and build the portfolio of real estate investments.

A 1031 exchange that swaps a direct ownership structure for an indirect ownership structure could be useful for clients who want to stay invested in real estate but who would like more freedom to diversify and mitigate concentration risk. Another benefit: An investor isn’t forced to reinvest their proceeds into another direct property that has a current value at the top of the market.

It could also benefit a client who wants to stay in real estate but without the financial and time-related burdens of direct ownership. As Johnson points out, that doesn’t always mean someone approaching retirement. “We’ve had a lot of clients come to us in their 30s and 40s because they’re at that life stage where they're devoting a lot of time to their marriage, their career, and their children,” he says.

Other clients may find this approach useful in estate planning because it also allows an investor to divide ownership among heirs more easily than with traditional real estate options.

A simple fix for rising values

A 1031 exchange doesn’t only apply to complex planning issues. Quite often, a 1031 exchange is used to solve a simple problem: a property that has appreciated considerably over time and carries a significant potential tax liability. Leveraging a 1031 exchange to invest into a DST may be beneficial when it comes to estate planning. “If someone wants to take a real estate investment with a lot of appreciation and a low basis and migrate those funds to a DST, the stepped-up cost basis would still apply if the owner of the DST passes away,” Johnson says.

For many clients, real estate offers an appealing way to pursue income and provide important diversification. A 1031 exchange can provide these clients with a powerful tool to manage the often burdensome tax bills that can arise from real estate investments¹. By educating clients about these plans, advisors can help their clients make the most of these investments today and in the years to come.

¹Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.