If you are thinking about selling your rental property, a tax-deferred 1031 exchange may be a path to consider. The deferral of taxes resulting from the sale of investment property allows for investors to reposition investment real estate to help meet their objectives while preserving all of their equity so it continues to work for them.
Here are five frequently asked questions we received from rental property owners about 1031 exchanges and investment options in 2022.
Aside From Tax Savings – What are the Benefits of a 1031 Exchange?
Reducing tax liability on relinquished investment property is certainly the most well-known benefit of a 1031 exchange. This allows investors to defer tax on capital gains and depreciation recapture and acquire replacement properties at pre-tax dollars.
A 1031 exchange also introduces several lesser-known exchange benefits depending upon the ownership structure of the replacement property. Exchanging into a Delaware Statutory Trust (DST) or Triple Net Lease (NNN) properties, for example, enables investors to “trade up” and fractionally own institutional-grade real estate with higher income potential.
As popular passive real estate alternatives, DST and NNN properties also allow investors to eliminate active management responsibilities and diversify risk by exchanging into multiple properties and various asset types and geographical markets.
A 1031 exchange into DST properties is also a powerful estate planning tool. The capital gains tax can be eliminated altogether on replacement property inherited by heirs as the “stepped-up basis” of the property will be equal to its fair market value on the date of your passing.
What Is the Potential for 1031 Exchanges to Be Eliminated Under the Biden Administration?
Both democrats and republicans have threatened to eliminate the 1031 exchange provision in recent times, making this a great question to examine regardless of who holds office. Biden’s plan would eliminate the use of 1031 exchanges for real estate investors making over $400,000 in annual income and eliminate the step-up in basis for assets acquired from a decedent.
Several respected economists have studied the impacts of the Biden proposal and the results are far from favorable for Americans. “Raising the capital gains (tax rate) and eliminating 1031 would create a 20 percent decline in commercial real estate values. Real estate would be subject to the capital gains tax at a very high rate,” said Ken Rosen, chairman of Rosen Consulting Group and the Fisher Center for Real Estate and Urban Economics at the Haas School of Business at the University of California, Berkeley.
While eliminating the 1031 exchange may appear to boost tax revenue on the surface, it could have far-reaching detrimental effects on the commercial real estate industry and economy. These impacts include a significant decrease in real estate investment, transaction volume, liquidity, and property values – ultimately decreasing property taxes, jobs, and government revenue. The outcome of Biden’s proposal to eliminate the 1031 exchange is unknown and could disappear quickly or continue to evolve. We believe changes are unlikely, but the proposal is something that should be closely monitored.
What Are Suitable Replacement Properties to Consider for a 1031 Exchange?
Identifying a suitable replacement property can be a challenging and stressful decision. Several factors must be carefully considered when seeking to achieve the exchanger’s financial and lifestyle goals, including tax liability, ownership structure, property location and attributes, and overall market dynamics. Understanding your tax liability and setting financial and lifestyle objectives is a critical first step. These objectives should be based on what you are looking to accomplish today and well into the future. Key factors to consider include risk tolerance, cash flow, appreciation potential, liquidity, management control, and estate planning needs.
Most of our clients, for example, have owned and managed rental properties for several years. They are ready to retire and want to avoid taxes on capital gains when selling their highly appreciated properties. For these risk-averse investors, transitioning away from active property management and into passive real estate with high-income potential is highly desired. To completely defer taxes, the replacement property must be at a value that’s equal to or greater than your original property’s sale price. In our example above, the fractional ownership structure of Delaware Statutory Trusts (DSTs) and Tenant-In-Common Properties (TIC) offer the income potential, risk diversification, and passive management our clients are seeking.
How Do I Know if a 1031 Exchange is Suitable for Me?
Although 1031 exchanges are very popular and have many benefits, they may not be suitable in certain situations. That is why it is important to first determine whether an exchange is the right decision and should be based on your objectives, financial situation, and tax liability that would result from selling your investment property. This is because tax liability not only includes gains taxes but is also impacted by other income, other asset sales, and any unused loss carryforwards. As a result, your total tax liability could be substantial depending on which state you live in. For example, investment property owners in California can pay as much as 42.1% in tax on the sale of investment property.
How Do I Get Started with a 1031 Exchange?
Once you have made the decision to perform a 1031 exchange, your first step should be to select a 1031 exchange firm to ensure your exchange is successful and to guide you through the exchange process. Below are a few key steps when getting started with a 1031 exchange. For a more comprehensive understanding of steps, visit our website at www.re-transition.com and download our free guide: Understanding 1031 Exchanges.
Step 1: Select a 1031 exchange Firm. A good 1031 exchange firm should not only help you find, select and acquire a 1031 exchange qualified replacement property, but should also assist you in navigating the exchange rules, debt matching considerations, and unravel property ownership issues. There are quite a few 1031 exchange companies to choose from, however, like any industry, the level of expertise, years of experience, client-focus, due-diligence, and services offered vary greatly from company to company.
Step 2: Identify potential 1031 replacement property (45-Day Rule). This step must be done within 45 days after closing on your relinquished property so it’s a good idea to work with your 1031 exchange firm early on to identify suitable replacement properties.
Step 3: Enter a contract to sell your existing investment property. Work with your realtor/broker to get your existing investment property (Relinquished Property) listed and under contract.
Step 4: Select a Qualified Intermediary (QI) and open an exchange. Once your relinquished property is under contract, the next step is to open an exchange with a Qualified Intermediary. Required by the IRS, a qualified intermediary is the entity that holds onto the exchange proceeds while your replacement property is identified and releases the funds to acquire the 1031 exchange replacement property.
Note – The exchange must be opened with your qualified intermediary BEFORE the close of the sale of your relinquished property. Your qualified intermediary must also be notified of the identified replacement property.
The Bottom Line
IRS Section 1031 is undeniably one of the most generous sections of the tax code, however IRS rules are absolute and must be followed. Having the right team in place and working with a highly experienced 1031 exchange advisory firm will help you make the most of this advantageous transaction structure.
As Chief Exchange Strategist, Austin Bowlin leads the firm’s team of licensed 1031 exchange advisors and analysts and provides consultation on tax liability, deferral strategies, legal entity structuring, co-ownership arrangements, 1031 replacement property options, and Delaware Statutory Trust investments.
Real Estate Transition Solutions is a consulting firm specializing in tax-deferred 1031 exchange strategies and Delaware Statutory Trust investments. For over 26 years, they have helped investment property owners perform strategic 1031 exchanges by developing and implementing well-planned, tax-efficient transition plans carefully designed to meet their objectives. To learn more about Real Estate Transition Solutions, call 888-286-5395, or visit our website at www.re-transition.com/aoa.
The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Such offers are only made through the sponsor’s Private Placement Memorandum (PPM), which is solely available to accredited investors and accredited entities. Case studies and examples are for illustrative purposes and not representative of future results. There are risks associated with investing in real estate properties, including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies, and illiquidity. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your situation. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million dollars exclusive of primary residence) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney. Securities offered through Aurora Securities, Inc. (ASI), member FINRA/SIPC. Advisory services offered through Secure Asset Management, LLC (SAM), a registered investment advisor. ASI and SAM are affiliated companies. Real Estate Transition Solutions (RETS) is independent of ASI and SAM.