As a real estate investor, you most likely prefer to retain any profit gained from the appreciation in your real estate assets rather than paying it in capital gains taxes when you sell a property and reinvest in another. One strategy for deferring the obligation to pay tax on a capital gain is executing a 1031 exchange.
The term refers to Title 26, Section 1031 of the Internal Revenue Code, and while it has changed over the years, the IRS first allowed land exchanges between farmers in 1921. The provision permits investors to sell one investment property and reinvest the proceeds in another “like-kind” asset while deferring the payment of capital gains taxes on the appreciation applicable to the relinquished property. The exchange also allows deferral of depreciation recapture and Net Income Investment Taxes, plus state capital gains taxes. Note that using a 1031 exchange can help you work toward other investment goals as well, like broadening your geographic footprint, changing sectors, or altering the composition of your portfolio in different ways.
While the successful completion of a 1031 exchange can be a great tool to help investors defer their tax obligation on the sale of appreciated property, there are some pitfalls to watch out for. Failing to follow the IRS' rules governing the process precisely will derail the exchange and the deferral, potentially resulting in an unexpected and unwanted tax bill. Among the key considerations are:
During some economic cycles, asset financing can be challenging to obtain and slower, which could cause an investor to risk missing deadlines in the tight time frame of a 1031 exchange. Therefore, investors looking for an option to complete their deal with a specific level of debt may want to consider exchanging into a Delaware Statutory Trust, or DST.
A DST is a pre-packaged investment that investors can buy in customized amounts, typically with low minimums. DSTs cover a range of commercial properties across all sectors and offer access to passive income and tax advantage potential with professional portfolio management. Since 2004, the IRS has deemed DST products eligible for 1031 exchange on both entry and exit, increasing their appeal for investors in a time crunch or struggling to replace value or debt within the exchange process. However, these investments have risks and rewards, including liquidity considerations. Always consult your financial advisor.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. No public market currently exists and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.