Working 1031 Exchanges Into Your Real Estate Portfolio Strategy

Are you a real estate investor or business owner with appreciated real estate? How about a family office looking to expand its alternative investments into the real estate realm? Holding real estate can unlock exclusive tax benefits, like deferred gains and business deductions, while still appreciating in value. In fact, certain markets, like Seattle and Dallas, have experienced a 175% and 152% home price appreciation over the last 20 years, respectively.  

In this article, we'll explore the fundamentals of 1031 exchanges, including how they work, key deadlines, and the tax advantages. We'll also look at potential risks and challenges and what the future of 1031 exchanges legislation holds.  

A 1031 exchange, known as a like-kind exchange, is a strategy that allows real estate investors to defer capital gains taxes on investment property sales. 1031 exchange assets are generally restricted to real property, such as buildings and land.  

When completed, real estate investors and family offices can defer significant capital gains that would otherwise be due in the tax year of the sale. It's important to note that a 1031 exchange does not eliminate capital gains taxes. Instead, it defers the tax until the replacement property is sold.  

To defer capital gains taxes, you must follow specific criteria and rules set out by the IRS. Let’s go over a few of these requirements in more detail. 

Like-Kind Property  

The first rule is that the properties involved in a 1031 exchange must be like-kind. This generally means real property that is held for investment use. For example, you wouldn’t be able to exchange a residential duplex for a primary home. However, you could exchange a residential duplex for a commercial rental building.  

Properties used for personal use, such as a primary home, do not qualify. This means that you can’t exchange a second home in Florida for a single-family rental property. Real estate investment trusts, known as REITs, are also excluded from participating in 1031 exchanges.  

Defined Timelines 

The IRS sets concise timelines for 1031 exchanges. Breaking just one of these deadlines could result in your capital gain becoming taxable. There are two important deadlines:  

• 45 Days – You must identify the replacement property within 45 days of the sale of the original property.  
• 180 Days – You must complete the entire 1031 exchange process within 180 days of identification of the replacement property.  

These deadlines cannot be extended, which is why it’s important to have a replacement property and a buyer lined up for your original property.  

Consistent Purchaser 

The taxpayer or business identification number must be the same on both the original and the replacement property. This means that if the original property is in your family office’s name, the replacement property must also be titled the same. You can’t mix and match ownership.  

Property Value 

To maximize the value of your capital gains tax deferral, the replacement property must be of equal or greater value than the original property. This ensures all proceeds from the sale are reinvested and can avoid a complex capital gains tax calculation. For example, if you sell your original property for $400,000, the replacement property should be bought for $400,000 or more.  

It’s also important to note that the amount of debt taken on should also match or exceed the original property. Any difference in liabilities can be taxable if the full amount of cash is not used. Let’s say that you sell a property for $400,000 and have a $300,000 mortgage. The new property should have at least $100,000 of cash put into it.  

Qualified Intermediary 

Since 1031 exchanges can be complex, the IRS requires the use of a qualified intermediary. A qualified intermediary acts as the middleman, receiving the funds from the original sale and applying them to the replacement purchase. The IRS does not allow you to receive sale funds directly.  

Tax Return Reporting 

Even though you are deferring capital gains taxes by using a 1031 exchange, you still need to report the sale on your tax return by filing Form 8824. This form outlines key information for the IRS, including the sale price of the original property, the purchase price of the replacement property, the dates you sold the original property, the dates you identified and purchased the replacement property, and the gain you are deferring. Form 8824 is required to be attached to your return in the year that you transfer the original property.  

Basis Adjustment 

1031 exchanges do not eliminate taxes but defer them through basis adjustments. Let’s say that you are deferring $100,000 of capital gains. You purchase the replacement property for $500,000. Your new basis in the property will be $400,000. This means your depreciable base is now only $400,000. This makes it important to evaluate the trade-off between capital gains taxes and a lower depreciable base. Adjusting the basis in the replacement property is a simple way to keep track of deferred gains. When you go to sell the replacement property, your cost basis will be $400,000, not $500,000, which will result in the picking up of the $100,000 capital gain deferral.  

1031 exchanges have numerous benefits for real estate investors and family offices. Let's explore three of the top advantages.  

Tax Deferral  

The top benefit of 1031 exchanges is the deferral of taxes. Let's say that you have a property that has appreciated by $200,000. Instead of paying capital gains tax on this $200,000, you can defer the tax bill until you sell the replacement property. Using a 1031 exchange can also defer the depreciation recapture tax. The combined tax deferral of capital gains and depreciation recapture can free up more capital to invest in real estate and other assets.  

Investment Equity Growth  

One of the benefits of using 1031 exchanges is the ability to reinvest property gains into more valuable properties. This allows your investment equity to appreciate quickly. For example, let's say that your capital gains tax rate is 20%. You sell a property that has a $300,000 gain, resulting in $60,000 of capital gains taxes paid. By using a 1031 exchange, you can defer paying the $60,000 capital gains tax and reinvest the full proceeds directly into a new property.  

Portfolio Diversification 

By deferring capital gains taxes, you can use 1031 exchanges to upgrade or diversify your real estate portfolio. Let's say that you have a property that's underperforming. However, you have significant appreciation that would result in a $100,000 capital gains tax bill. Instead of holding onto the underperforming property or paying the capital gains tax, you have the ability to defer the tax and upgrade the property.  

Legislation surrounding 1031 exchanges is constantly changing, especially as the IRS looks to tighten qualification criteria. One recent legislative change came out of the 2017 Tax Cuts and Jobs Act, when personal property was eliminated from the eligibility list. Now, 1031 exchanges only apply to real estate.  

Other proposed legislative changes include capping high-value transactions, directing investments toward different housing initiatives, and offering increased incentives for green and sustainable investments. The current administration is pro-1031 exchange; however, past administrations have attempted to completely dismantle 1031 exchanges. Due to lobbying and industry advocacy, the likelihood of 1031 exchanges being wiped from the tax code is small.  

1031 exchanges can be a powerful tool for real estate investors, business owners, and family offices to defer capital gains taxes on appreciated property. However, strict criteria must be met to qualify for this tax advantage, making it important to work with a professional throughout the process. 

If you want to learn more about 1031 exchanges, or wish to consult a tax expert, schedule a meeting with KDG's tax team today!