You might own an investment property that you’re ready to sell. Perhaps you want to “trade up” to another real asset with a potentially better cash flow. Or you might want to invest in a property offering potentially higher appreciation.
The 1031 exchange can be a way to defer capital gains and depreciation recapture taxes on the sale of your current property. At the same time, a 100% occupied duplex could be a viable option as a 1031 replacement property, as you could benefit from cash flow and rent growth.
However, selling your relinquished property and investing in an occupied duplex has tax and other implications. It’s a good idea to understand the potential pros and cons before you consider such an investment strategy.
Possible Advantages
You could realize the following benefits in targeting a duplex as a replacement property:
Cash flow. If you acquire an occupied duplex through a like-kind exchange, you might receive immediate cash flow from in-place rents. Renting two units also means you could receive two income streams. This can minimize the risk of income loss if one tenant moves out.
Flexibility. As a duplex owner, you could rent both units. Or, you could live in one and rent the other. While this can provide you with living space, keep in mind that only the rented unit qualifies for a 1031 exchange.
Appreciation. The property could appreciate in value depending on where the duplex is located (and how well you maintain it). Deferring tax payments through a like-kind exchange can also provide you with the resources to upgrade the property, which can be beneficial when you want to sell.
Potential Disadvantages
While duplex ownership can provide investment advantages, it can also have the following downsides:
Tenants. An occupied duplex means you must deal with tenants that are already in place. You won’t have had the opportunity to vet them. This is fine if the renters are respectful and responsible. However, problems could arise if those tenants are destructive and constantly late with rent.
Limited property pool. You have 45 days to identify a replacement property after your relinquished property closes. Targeting only duplexes could shrink your options. Failure to identify a replacement property within 45 days would void the exchange.
Costs. Owning a duplex comes with operating, deferred maintenance, and other unexpected expenses, like replacing a roof, upgrading a faulty HVAC system, or replacing broken appliances.
Preparation is Key
Acquiring an occupied duplex through a 1031 exchange can be a way to diversify your holdings while deferring taxes. It could also provide cash flow and the possibility of appreciation.
But before taking this path, perform due diligence, review lease agreements and tenant history, and have inspectors on site.
Also, be sure to work with professionals knowledgeable about like-kind exchanges, residential rentals, tax implications, and other issues. These experts can help ensure that the duplex you receive is an advantageous addition to your real estate investment portfolio.
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.