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Choosing Between a 1031 Exchange and a Taxable Sale

15th Aug 2023

If you own a business or investment property and it’s time to sell, here are a few reasons why a 1031 exchange may be the right choice.

The US real estate market has seen a lot of fluctuations since the COVID-19 pandemic, with a competitive market clashing with high interest rates to make predictions difficult. Many property owners may be considering selling to take advantage of high prices, but aren’t thrilled at the prospect of paying the capital gains taxes that come with a sale of an investment property.

Internal Revenue Code Section 1031 (“§1031”) can provide incredible benefits to help investors maximize purchasing power and build wealth long-term. If you’re considering selling an investment property, here’s what you need to know about §1031 and why it might be right for you.

What is a 1031 Exchange?

§1031 applies to the sale of real property owned for business or investment purposes. If you own a rental home, multifamily building, or other investment property, you’ll likely have to pay federal (and potentially state and local) capital gains taxes and depreciation recapture upon sale. If your plan is to buy replacement property, these tax payments would greatly reduce your available capital and limit your options for reinvesting.

§1031 allows you to defer payment of the capital gains taxes and depreciation recapture if you structure the transaction as a qualifying exchange rather than a sale followed by a purchase. You won’t have to pay those capital gains taxes unless you sell the replacement property in a taxable sale. This allows you to use all of your sale proceeds to increase your buying power.

There are two main kinds of 1031 exchanges, forward and reverse. In a forward exchange, the relinquished property is sold first, after which the taxpayer has until the earlier of 180 days or the due date (including extensions) of the taxpayer’s tax return for the taxable year in which the relinquished property was transferred to purchase a like-kind replacement property. The definition of a like-kind property is fairly broad and can mean many other types of real property used for business purposes.

In a reverse exchange, the replacement property is acquired first, after which you’ll have a similar period of time (generally 180 days) to sell your relinquished property. Because of this flexibility, you can initiate a 1031 exchange either when you find a property to buy or when you find a buyer for your property. It’s important to understand the safe harbor rules of 1031, but if you follow them correctly, this method of tax deferral can provide major benefits.

How IRC §1031 Can Help You Defer Taxes

One important fact to remember is that tax deferral is not tax avoidance. You will still eventually owe the deferred taxes if you sell your replacement property in a taxable sale. However, if you believe you will have a lower tax burden at that time (due either to changes in tax policy or falling under a lower income bracket in retirement), you could end up paying less.

Of course, larger tax bills are not necessarily a bad thing. §1031 allows you to use your sale proceeds to purchase a larger replacement property or a wider portfolio of properties than you would have been able to without §1031. Being able to use those gains is like having an interest-free loan from the government to pursue investments that might have been out of your reach without §1031. By the time you eventually sell your replacement property, its value may be such that you’ll owe a sizable amount in capital gains taxes, but it’ll be because you’ve built up a considerable amount of wealth.

You can perform another 1031 exchange when you sell the replacement property, keeping the process going as part of an estate planning or retirement planning strategy. And if you hold your replacement property until death, it’s possible your heirs could end up with a lower tax burden on the property if they’re eligible to receive a step up in cost basis.

Without §1031, none of this would be possible. You’d have to pay capital gains taxes and depreciation recapture at the time of sale, and be left with less capital to invest in your future.

Who Can Do A 1031 Exchange

Despite what you may have heard about this being a tax strategy for wealthy land owners, §1031 can be utilized for many types of property held for investment or business purposes. It can also be used in a wide range of ownership structures.

The types of properties that can be a part of a 1031 exchange can include rental homes, multifamily apartment buildings, retail storefronts, warehouses, commercial complexes, vacant land, leasehold interests with 30 or more years remaining, conservation easements, vacation rentals, cell towers, or even an interest in a Delaware Statutory Trust. You don’t have to be wealthy to take advantage of the benefits of 1031.

More benefits of a 1031 exchange

Here are some additional advantages of §1031 that many investors don’t realize:

  1. §1031 preserves your equity and puts it toward its best use. If you’ve been steadily paying off the mortgage on your rental property for many years, you’ve likely built up a significant amount of equity that can help you secure loans and other opportunities. If you perform a taxable sale, capital gains taxes will eat into that equity in a major way. With §1031, you hold onto your equity as long as possible and can use it to continue to build wealth.
  2. 1031 can increase cash flow. With §1031, you can exchange into a property that generates more income than the one you currently own. For example, if you own a duplex with high equity and exchange into a multifamily apartment building by adding more cash and/or loan capital, you’ll now not only be invested in a more valuable property, but will have more tenants that can provide more rental income.
  3. 1031 helps you diversify. 1031 can be used for multiple properties, not just one. You could exchange from one property into two, or even use DSTs to be invested in a portion of multiple property types. The same is true the other way: if you own multiple single-family residences, you could sell them when the market is attractive and consolidate into an industrial warehouse to cut down on the maintenance and oversight you have to do. And with triple-net or DST properties, this maintenance could be cut to almost zero while you enjoy the passive income.
How to perform a 1031 exchange

Meeting the requirements of §1031 is complicated, and you should always work with legal and tax professionals who can give you the right advice about how to proceed. There is a strict timeline by which you must identify your replacement properties and deadlines for when the property must be purchased.

You’ll also need a Qualified Intermediary to hold funds during the exchange. JTC has decades of experience as a QI and a team with expertise in all types of exchange scenarios. Regardless of the complexity of your exchange, JTC can help.

While 1031 exchange may not be right for every situation, if you’re considering selling business or investment property, it’s worth exploring whether a 1031 exchange could help you build more wealth and secure a more prosperous future.

Learn more about JTC’s 1031 exchange service

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