What Are The Advantages and Disadvantages of a 1031 Exchange?

Of all the tools in a real estate investor’s toolbox, none works quite like the 1031 exchange. 

A 1031 exchange can offer investors many potential advantages, but there can be some disadvantages as well. Let’s take a closer look at each. 

Types of 1031 Exchanges 

There are three main types of 1031 exchanges: 

• Deferred/delayed. This is the most common type of exchange. You sell an investment property and have 45 days to identify a replacement property. You must close on the replacement property within 180 days from the sale of your relinquished property. 
• Reverse. You buy a replacement asset prior to divesting your original property. Timing can be tricky in a reverse exchange. 
• Simultaneous. You acquire a replacement asset at the same time as you divest your relinquished asset. Timing here is even trickier – that’s why simultaneous exchanges are rarely undertaken. 

Some investors also undertake improvement exchanges, where they make improvements on a replacement property using exchange funds. Again, timing is crucial, since you have just 180 days from closing on your relinquished property to complete all necessary improvements. All funding for improvements also must be made by a qualified intermediary – you can’t fund the work yourself. 

Now that we’ve given an overview of the exchange process, let’s take a look at the advantages of 1031 exchanges. 

Advantages of 1031 Exchanges 

There are a host of potential advantages of completing a 1031 exchange. These include: 

• Tax deferral. One of the primary advantages of completing a 1031 exchange is that it provides a means for investors to defer paying taxes on any realized capital gains when they sell an investment property so long as they roll over the entirety of the sale process into a like-kind replacement asset. Investors also can defer depreciation recapture, state capital gains taxes (when applicable), and Affordable Care Act taxes. Taken together, these taxes could chip away as much as 35 percent of the profits from your sale. 
  
  
• Exposure to new markets and different asset classes. You aren’t limited to your home market or any particular geographical region when completing a 1031 exchange. You can deploy your exchange capital into any region of the country that fits within your investment criteria. You also can swap asset classes, switching from office to retail, for example. 
  
  
• Diversification. Since you are free to exchange into different asset classes and geographical markets, you can diversify your real estate holdings by both asset type and region. This type of diversification can help manage investment risk and provide a buffer from economic downturns in large metropolitan areas, or a slump in a certain asset class, such as increased office vacancy due to work-from-home trends. 

• “Swap Til You Drop.” Since there’s no limit to the number of 1031 exchanges you can complete, you essentially can keep swapping properties until you die. Your heirs will inherit your exchange properties at a stepped-up basis to fair market value, which can erase your accumulated capital gains tax liabilities. 
  
  
• Trading up. Exchanges allow you to potentially upgrade your real property holdings by class and within a certain asset type. You can exchange from a class B multifamily property into a class A apartment complex, for example. You also can exchange into higher-value properties that may provide increased cash flow from rental payments. 
  
  
• Relinquish management duties. Exchanging into a Delaware Statutory Trust allows investors to enjoy many of the benefits associated with real property ownership without the hassles of direct property ownership.  

There may be other advantages to a 1031 exchange, such as divesting jointly owned real estate for a single ownership structure. However, there can be some pitfalls as well.  

Disadvantages of 1031 Exchanges  

While 1031 exchanges can benefit investors in many different ways, they aren’t without their potential drawbacks. Some disadvantages of 1031 exchanges can include: 

• No access to investment capital. If you want to defer 100 percent of your gain, you’ll have to roll over 100 percent of your investment capital. That includes your original basis as well as all of your realized gains. You can take cash out of an exchange, but you’ll have to pay capital gains taxes on any amount that’s not reinvested. 
  
  
• Strict timelines. Investors may find the most difficult aspect of completing a 1031 exchange is meeting the Internal Revenue Service timelines of 45 days to identify a replacement property and 180 days to close. These timelines aren’t fungible – miss one, and you’ll likely end up with a straight sale rather than an exchange. You’ll immediately owe all taxes due on the sale of your investment property. 
  
  
• Strict guidelines. The IRS is equally stringent on exchange rules. You must use a Qualified Intermediary throughout the exchange process – if you haven’t engaged a QI prior to close of sale, you’re already too late. Properties must align in value, and mortgage debt must match as well. You can’t exchange into a second or vacation home (at least not for a few years), and you can’t have a disqualified person involved in your exchange. The list goes on. 
  
  
• Complexity. Exchanges are far more complex than straight real estate sales. There are multiple ways your exchange could go south. 
  
  
• Changes to regulatory or taxation rules. Investors may find the playing field changes for the worse over time. 

Closing Thoughts 

A 1031 exchange can be a powerful tool, especially when it comes to deferring capital gains taxes. While there can be quite a few potential advantages with exchanges, there are an equal number of drawbacks. Execution, timing, and an experienced Qualified Intermediary are essential elements to successfully completing any 1031 exchange.