A 1031 exchange can be a great way to delay taxes on gains from your property's sale. Rather than handing a chunk of your gains over to the IRS, you can purchase another property from your sale's proceeds and delay your tax bill for years down the road. However, even with these advantages, a 1031 exchange may not be the right route for everyone. In this article, we'll look at a few areas to consider when deciding to do a 1031 exchange or not.
Does A 1031 Exchange Make Sense?
If the liability is low (i.e., low tax bill), it might make the most sense to reset your cost basis. A small tax bill due to low tax rates may mean it is more advantageous to avoid a 1031 exchange. With a 1031 exchange, you only have 45 days to pick a replacement property. Also, rolling your gains into another property means tying up your money long-term in an illiquid asset. For paying a small amount in taxes, you keep liquidity and don’t have to deal with the 1031 exchange process.
Consider the opposite scenario where you have a high amount of debt. Assuming the replacement property is of higher value, you’ll need to reinvest with additional debt or more cash equal to the difference between the net purchase price and the reinvested equity. It isn’t necessary to completely replace the debt. You can also use cash instead. However, you may end up investing more of your cash into the (higher-valued) acquired property than the relinquished property.
Additionally, far too often we see people buy the wrong property to meet their echange needs. In other words, try not to concentrate too much on the equity and debt amounts when doing a 1031 exchange just so you can avoid all taxes.
What if your property hasn't gone up much in value, but you've owned it for several years? Each year, you will have taken depreciation. This depreciation must be recaptured, which can generate a fairly significant gain, even though the property may have appreciated very little.
Consult with a CPA when deciding to do a 1031 exchange. We can provide estimates from our experience, but to account for other gains, losses, and items outside of your exchange, it is always best to consult an accountant versed in 1031 exchanges.
Selecting A Qualified Intermediary
Not all qualified intermediaries (QI) are equal, and there is not much regulation required to protect investor assets. Whereas the 1031 exchange process is an actual IRS code and must follow specific procedures, the QI industry does not have any regulations.
It’s best to find a QI with a lot of experience who may be less prone to making mistakes. Mistakes made by the QI can result in a bad 1031 exchange experience. Do as much research as possible on potential QIs before selecting one.
What Are Your Objectives?
Whether it is you or an entity doing a 1031 exchange, it’s important to understand what your objectives or goals are. Are you striving to:
- Maximize returns
- Preservation of wealth
Working with your advisor can help ensure that your 1031 exchange is structured to meet your objectives.
Managing The Asset Once The Exchange Is Completed
When buying direct property, there is more control and flexibility, but at a higher risk. Unlike a more passive investment, such as a Delaware Statutory Trust (DST), the property will need to be maintained (repairs throughout the property’s life and updates before selling). You might need to bring additional collateral to the investment to sustain the property.
Are you going to have a personal guarantee to get the needed financing? Being passive might relieve the headaches to management, but decisions are delegated to the partner you've put your trust into without the ability to sell. If you are more hands-on with your investments, you’ll likely find passive investments undesirable.
Being informed before getting involved with a 1031 exchange is always best. Understanding the tax consequences, finding a secure QI, focusing on your goals, and the desired amount of control can all lead to a successful exchange.
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.
1031 Exchange Guidebook
The 1031 Investor's Guidebook