How to Assess Whether Clients Are a Good Fit for a 1031 Exchange

For some real estate investors, a 1031 exchange can be a powerful financial planning tool. But before you start the paperwork, take a holistic look at your client’s situation. Their needs, goals and finances will help determine whether selling a property and then completing a 1031 exchange is right for them.

“Real estate should be looked at like any other asset,” says Rob Johnson, head of wealth management for investment property wealth management firm Realized. “What’s the risk? What’s the reward?” It’s only after determining that the reward outweighs the risk, Johnson says, that advisors and clients should move forward with a 1031 exchange.

Assess your client’s life stage and retirement plans

Your client’s unique needs and goals should drive every financial decision, and a real estate sale with an eye to completing a 1031 exchange is no different. Here are some factors to take into consideration when deciding whether a 1031 exchange is a solution for your clients.

Life stage. Where is your client in their life? Are they just starting a family, working long hours, switching careers, moving? Ask how they see real estate ownership fitting into their day-to-day life in the context of the other demands on their time. If they’d rather focus on something other than the responsibilities of direct real estate ownership, they may want to explore other investment structures. Their health status also merits a close look. If they’re becoming less mobile, property management can be more difficult.

Role of real estate investing. Do they view their investment property primarily as an income generator or a growth investment? Their views may change as they move from accumulation to wealth harvesting.

Retirement goals. Walk through the specifics of what your client envisions for retirement. If they plan to move to another state, split their time among far-flung relatives, travel the world or transition to a snowbird schedule, property management may become more difficult. On the other a hand, a client who sees landlord duties as a pleasant way to keep themselves busy during retirement may relish direct ownership.

Evaluate the larger financial picture

Whatever your client’s goals for their property, their real estate holdings should always be considered in the context of their larger investment portfolio. When you look at how much income a property is generating, compare the return on that investment with returns on their other assets. “Unless the advisor gives the client a holistic view of which assets are generating the return they’re hoping for, something could get missed,” Johnson says.

Another comparison will create perspective, too: the value of your client’s direct real estate holdings as a portion of their total portfolio or net worth. Calculating that will help them judge whether their current holdings leave them vulnerable to concentration risk, particularly when the holdings are a single property or several properties in close proximity.

The physical location of your client’s real estate assets can also have financial implications. Property taxes in a high-tax state can eat into investment income, and the real estate market outlook can differ widely by state or region. Is direct ownership preventing them from owning more desirable properties? If so, it’s worth considering a sale or exchange.

Consider a sale

Together, you and your client may realize it’s time to sell current real estate holdings—even if real estate has an ongoing role to play in your client’s wealth plan.

The biggest potential challenge with a sale is the tax implications. For some clients, the capital gains tax bill could be enough to dissuade them from selling, even if they’d prefer to let go of the property. But if they’re aware of a strategy to keep the capital working, maintain a desired portfolio exposure and hold on to real estate’s income potential, the choice can be easier to make.

Looking at a 1031 exchange

For clients who fit the above criteria, consider suggesting a 1031 exchange. Qualifying transactions can make it possible for a client to defer capital gains taxes and keep the proceeds of the sale working for them. Of course, suitability, timing for the transaction and related fees need to be assessed as well to make sure this type of exchange will work for a particular client, but it can be a very useful tool.

One way investors can use a 1031 exchange is to relinquish a directly owned property and acquire shares in a Delaware Statutory Trust (DST) or a tenant-in-common (TIC) arrangement. Changing the ownership structure may work well for clients who want to maintain a real estate position but who don’t want the responsibilities or risks of direct ownership.

The flexibility of a 1031 exchange can offer clients and their advisors an effective wealth planning tool. As with all wealth planning activities, it has to be considered in the context of a client’s overall wealth picture. Those who choose to proceed will want to consider the ideal ownership structure for the acquired property, determine timing and find a strong partner who has the expertise to help manage the exchange transaction. Completing the transaction with the right support can make a smart move feel like an even better decision.

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.