The origins of 1031 Exchange legislation date back to the Revenue Act of 1921. Since then, with some revisions along the way, the 1031 Exchange has become a popular investment tool for businesses and investment property owners looking to defer taxes after a sale.
According to the IRS website (irs.gov), Internal Revenue Code Section 1031 provides an exception and allows a person or entity to postpone paying tax on a gain if the proceeds are reinvested into a similar property as part of a qualifying like-kind exchange. A deferred gain in a like-kind exchange is tax-deferred, but it is not tax-free. A property is considered like-kind if it is of the same nature or character, even if it differs in grade or quality. For example, if an apartment owner sells, they may exchange into another apartment or SFR if used as a rental property and not a primary residence. Following are the fundamental requirements for a 1031 Exchange: 1) must be another like-kind investment property; 2) the replacement property must be of equal or greater value; 3) all proceeds for the sale must be invested in the replacement property; 4) must be the same title holder and taxpayer; 5) must identify the new replacement property (up to three) within 45 days of the sale, and; 6) must close on the replacement property within 180 days of the initial sale.
The 1031 Exchange is ideal, not only to defer taxes, but to take advantage of a property that has appreciated in value, allowing the investor to trade up to a larger investment property that offers increased income potential and a better return on investment (ROI). However, one downside with investment property exchanges is that if inventory is limited, an investor may feel forced into an undesirable purchase in order to meet the 45 and 180 day time requirements. If the investor is unable to identify a replacement property within 45 days, they would be subject to capital gains tax. Long-term capital gains tax rates can be upwards of 15% to 20%, so it is easy to see why investors prefer to defer taxes and reinvest into another property.
An alternative investment that has become increasingly popular as an IRS approved 1031 Exchange option over the last 20 years is the Delaware Statutory Trust (DST). A DST is a real estate ownership structure where multiple investors each hold an undivided fractional interest in the holdings of the trust. The trust is established by a professional real estate company, referred to as a “DST sponsor” who first identifies and acquires the real estate assets. As individuals invest, their investments displace the capital used by the DST sponsor to acquire the property until it is eventually wholly owned by the investors. Investors own a beneficial interest in the trust. This means that investors hold a percentage of the ownership, and no single owner can claim exclusive ownership over any specific aspect of the real estate.
Nearly all commercial real estate property types are held as DST properties, including the four major property types: multifamily, office, industrial, and retail. There are some niche property types as well, including senior housing, medical offices and self-storage. DST real estate is typically comprised of institutional-grade assets with competitive income potential. Due to the large purchase price of typically $30 million to $100 million, these assets would otherwise be unattainable for the typical investor but are accessible through fractional ownership offered by a DST.
There are inherent risks with any of the investments mentioned and this information is intended to be informational in nature only. While we have given a general overview of the 1031 Exchange as a way of deferring taxes, we always recommend that anyone considering these types of investments seek the advice of their CPA and attorney.
Mike Harper and Peter Hazdovac are both licensed Realtors® with Keller Williams Realty. For more info., visit www.harperhazdovac.com