Section 1031 has helped property owners build wealth through like-kind exchanges since 1921. While some rules have evolved over the years, 1031 is still a valuable strategy for real estate investors. If it's been a while since your last exchange, you might not realize some of the ways 1031 can enhance your real estate strategies. Here are a few 1031 highlights that financial advisors should share with their clients.
The Flexibility of “Like-Kind”
IRC Section 1031 allows property owners to defer capital gains taxes and depreciation recapture on the sale of real property held for business or investment purposes if they acquire a “like-kind” property within a set time frame.
Before 2018, qualifying exchange property included just about anything owned for business or investment purposes, from artwork to aircraft and all kinds of real estate in between, but now 1031 only applies to “real property.” For real estate investors, the good news is that the definition of “like kind” is still fairly broad. This means you can exchange between many different kinds of real estate, so long as both the property to be sold and the replacement property are used in a trade or business or held for investment.
Exchangeable property includes single-family rental homes, multifamily apartment buildings, retail or office space, warehouses, farmland, vacant land, certain oil, gas and mineral interests, or even shares in a Delaware Statutory Trust (DST).
DSTs have become quite popular because they allow for the purchase of a proportional interest in larger commercial properties or a portfolio of properties overseen by a professional property manager, providing diversification and consistent income through a passive investment that still qualifies as a like-kind property under Section 1031.
There are also property types you may not realize can be exchanged. For example, if you own a vacation property that is used occasionally for personal use part of the year but is rented out as a short-term vacation rental most of the year, it may be used in a 1031 exchange per the safe harbor outlined in Revenue Procedure 2008-16. Always consult your tax adviser when embarking on this type of exchange. In order to qualify for tax deferral under Section 1031 certain conditions must be met, including that the property must rented out for at least 14 days per year, at market rate, and your personal use cannot exceed 10% of the days rented.
This flexibility in property types makes 1031 attractive to investors of many shapes and sizes. And by employing advanced strategies, it’s even possible to secure alternative strategies to minimize a taxable event resulting from a failed exchange.
Advanced Strategies for 1031
Some property owners may be hesitant to engage in an exchange now because of the difficulty in timely securing the right replacement property. In a competitive market, many exchangers employ alternative strategies such as a reverse exchange, which allows the security of acquiring the replacement property before the relinquished property is sold.
Even when pursuing a more traditional forward exchange, there are strategies to be considered. Exchangers have a 45-day deadline to identify replacement properties. They can identify up to three properties without any additional restrictions. By taking advantage of all of the identification slots, and potentially using a DST as an option for at least one of the identified properties, you’ll increase your chances for a successful exchange.
That said, not all exchanges are successful at the end of the day. One way to mitigate the impact of a failed exchange is “tax straddling,” which involves timing the exchange so the sale falls in one tax year and the receipt of proceeds in the following year. This will be treated as an installment sale and IRC Section 453 can be employed to defer recognition of a portion of the gain until the following year.
If you are unable to find a replacement property of equal or greater value to the relinquished property, the leftover cash is known as the “boot,” and will be subject to taxation. Rest assured, there are strategies for minimizing boot as well. An exchanger can purchase additional Replacement Property, construct improvements to increase the value of the Replacement Property, or invest in other tax advantaged vehicles to defer more taxes.
Taking Advantage of 1031 While it Lasts
One reason to pursue an exchange in 2023 is the uncertainty of tax reform in the future. Over the years, Section 1031 has been targeted multiple times, the Biden Administration even proposed eliminating it altogether as part of its 2024 budget. No one has a crystal ball, and benefits like this don’t come along every day.
1031 has traditionally been a valuable tool in estate planning. Under current law, when an exchanger passes, the beneficiaries of the properties acquired via 1031 exchanges benefit from an immediate step up in basis, meaning teh adjusted basis to the beneficiaries goes to the fair market value on the day the property is inherited. They could theoretically wash away the taxes the exchanger had been deferring over the years. Unfortunately, there have been proposals to eliminate this benefit. To take advantage of 1031 as it is now, investors may want to act before any changes to the law can be passed. It’s worth investigating the current real estate market to see if it’s prudent to pursue an exchange now.
What Real Estate Investors Need for a Successful Exchange
If you or your clients are considering an exchange, solid advice from a tax professional is paramount, and not just on current real estate trends. 1031 has many specific rules that must be adhered to for the exchange to be successful. Experienced tax professionals and legal experts are a crucial part of the process, as is an experienced Qualified Intermediary (QI).
The best QIs offer greater security by keeping exchange funds in insured, fully-liquid account structures at highly-rated banks and protecting them with security measures including dual authorization on all disbursements to come from the exchanger and the QI. They provide greater transparency through a secure online portal that allows for 24/7 visibility of exchange funds balances and transactional information. And they can help navigate regulatory compliance by lending expertise to help on the tax professionals navigate less common exchange scenarios. By choosing the right QI, you can help design the ideal long-term strategy for real estate investments.
Jill Jones is senior director at JTC, a global professional services business with deep expertise in fund, corporate and private client services.