One of the most persistent economic realities investors must account for is inflation. This phenomenon impacts everything, from grocery prices to real estate. As you navigate the ups and downs of inflationary periods, it’s important to consider how various financial strategies may play a role in preserving purchasing power and supporting long-term planning. One such strategy is the 1031 exchange.
The like-kind exchange is primarily used for tax deferral, certain economic conditions—such as inflation—can influence how investors evaluate their potential benefits. Can inflation affect the perceived value of a 1031 exchange? In some cases, yes—but careful planning is essential. Below, Realized 1031 has shared a guide to help you better understand how these factors may interact.
Refresher on 1031 Exchanges
A 1031 exchange allows an investor to sell an investment property and reinvest the proceeds into another qualifying property, without recognizing capital gains at the time of the transaction. By adhering to IRS requirements—including timelines and use of a qualified intermediary—investors may defer capital gains taxes and reinvest more of their equity.
In addition to potential tax deferral, 1031 exchanges may offer the following strategic benefits:
- Preserve purchasing power, since tax deferral can allow the full proceeds of the sale to be reinvested.
- Portfolio diversification, as the IRS permits you to acquire a wide range of properties as long as each one fits the like-kind requirement
- Realignment of cash flow characteristics, by exchanging into properties with different income or risk profiles.
These potential advantages can be particularly relevant during periods of high inflation, depending on how various property sectors respond to rising prices and interest rates. While real estate has historically been used as a hedge against inflation, individual asset performance can vary.
The Effect of Inflation on Real Estate
Generally, increasing inflation rates are worrisome indicators for rising costs of goods and services. The real estate sector has historically responded differently to inflation than other asset classes, and in some cases, may retain or increase in value during inflationary periods. Several factors contribute to this:.
- The fair market value of properties may increase during high-inflation periods, especially when the asset is in a high-demand market.
- To keep pace with inflation, rental rates also often rise, which can help offset higher operating costs and support net operating income.
- Debt becomes less expensive in real terms over time, particularly if the property was financed with a fixed-rate mortgage.
Because of these characteristics, real estate is sometimes considered part of an inflation-sensitive investment strategy. That said, active management of a real estate portfolio remains important—especially during inflationary cycles—since performance can vary widely across sectors and markets.
How Inflation May Influence the Value of a 1031 Exchange
One reason 1031 exchanges may be viewed differently during periods of inflation is the tax deferral they offer on capital gains. As property values rise, gains on the sale of appreciated assets may increase, which could result in a higher tax liability if sold without using a tax-deferred strategy.
Let’s say that you bought an apartment complex a few years ago for $700,000. Rising inflation rates have resulted in a new FMV of $900,000. If you sell the asset without a 1031 exchange, the $200,000 gain may be subject to capital gains tax, depending on your cost basis and applicable tax rules. By using a 1031 exchange, you may defer recognition of that gain and reinvest the full proceeds into another investment property—preserving more capital for reinvestment.
Upgrading to Potentially More Inflation-Resilient Assets
One thing you have to keep in mind is that inflation will not affect all property types to the same degree. For example, assets in the multifamily housing tend to perform better due to short-term leases that can be adjusted more frequently when compared to office buildings or retail properties with longer-term leases.
An investor may consider how 1031 exchanges can support the transition into assets perceived to be more inflation-resistant when identifying a replacement property. Acquiring properties in sectors with more frequent lease adjustments or lower operational costs may help reposition a portfolio during inflationary periods and manage risk exposure. Let’s say that you have an underperforming office space. You can swap this asset for a self-storage facility, which often has relatively low operational costs and short-term leases that may be adjusted more easily in response to inflation.
Leverage Considerations in a 1031 Exchange During Inflation
By using fixed-rate debt during inflation, the real (inflation-adjusted) cost of that debt decreases over time. A 1031 exchange can enable an investor to transition into a higher-value property, potentially taking on favorable financing terms while deferring taxes.
This approach—combining tax deferral with strategic leverage—may allow more capital to remain invested as property values and rents adjust during inflationary periods.
Key Considerations During Inflation
While 1031 exchanges may offer strategic benefits during inflation, they also come with important considerations:
- Market Timing: Inflation can drive up prices, but volatile conditions may increase the risk of overpaying for replacement properties.
- Interest Rates: Rising inflation often leads to higher borrowing costs, which may impact financing options or returns.
- Lease Structures: Properties with long-term leases may not adjust rents quickly enough to keep pace with inflation.
- Exchange Deadlines: Limited inventory and fast-moving markets can make it harder to identify replacement properties within IRS timelines.
- Policy Uncertainty: Future tax law changes could affect the treatment of 1031 exchanges or related estate planning strategies.
Careful planning and coordination with tax and real estate professionals is essential when executing a 1031 exchange in an inflationary environment.
Wrapping Up: 1031 Exchange and Inflation Connections
Inflation can create uncertainty for investors, but it may also prompt a reassessment of how to position real estate holdings. The tax-deferral benefits of a 1031 exchange can allow more capital to remain invested as property values change, while the exchange itself offers a pathway to realign into asset types that may respond differently to inflationary pressures.
Rather than viewing inflation solely as a challenge, investors may consider how it could signal a time to revisit long-term strategies and explore options for portfolio repositioning.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources: https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/
https://www.investopedia.com/terms/f/fixed-rate_mortgage.asp
