2023 is poised to be a big year for real estate owners who are looking to take advantage of the 1031 exchange, also known as the "like-kind exchange." A 1031 exchange is a tax strategy that allows real estate owners to defer paying capital gains taxes on the sale of a property by using the proceeds from that sale to purchase a similar property. In this way, owners can delay paying taxes on their gains until they eventually sell their new property, potentially many years down the road.
Owners can also elect to pass their property down to their heirs which will give them a step up in basis, eliminating the tax expense all together for the next generation.
Here are six reasons that 2023 will see a record number of 1031 Exchanges:
Rent growth plateau
2021 was a record year for rent growth across most US markets. Now with rental rates across many core asset classes like multifamily decelerating, investors in these properties are starting to see their rents plateau while their expenses and cost of capital continue to increase.
Many long-term owners are starting to recognize their upside in the near future is gone, yet their management headaches and expenses remain.
We are seeing more real estate owners show interest in doing a 1031 exchange into more passive assets like STNL properties. At Partners Commercial Real Estate, our pipeline specifically for 1031 exchange clients has increased significantly in recent months. We typically see an average of five to seven 1031 exchanges per year whereas right now we have nine active exchanges for an aggregate $37 million and more requests from owners to meet to discuss this service now than ever before. We attribute this to many investors having seen their property prices increase up to 70% in the past three years, and now rising interest rates and a slowing economy are causing the spigot on the gravy-train to slow.
Manufactured home parks, industrial, self storage and apartments have seen the highest CPPI change in the past decade, providing the strongest arbitrage opportunity for investors considering a 1031 exchange.
Bonus depreciation is expiring
Starting Jan 1, 2023, 100% bonus depreciation initiated by the Tax Cuts and Jobs Act in 2017 expired, and was reduced to 80%. That percentage will continue to decrease by 20% year-over-year until it burns off fully in 2026.
This accelerated depreciation has been a great tool used by exchange buyers to write off the entire purchase of qualified investment property in their first year which has been a great tool to offset major gains that same year—say from the sale of a business.
With this tax-saving tool slowly expiring, more investors are seeing that window close and positioning themselves to take advantage while they still can.
Cash is king
Real estate investors who see the greatest benefit from a 1031 exchange are those generally above the age of 65 who have owned a property 20 years or more. These owners have seen the most property appreciation and have benefitted from years of depreciation. These owners are also the most likely to have zero debt on a property.
Now, with interest rates from many lenders at 7.5% or greater on a traditional loan, debt buyers are out of the game and cash buyers in an exchange have the best money out there.
In January of 2022, the market felt like there were five buyers chasing every one deal. Now it feels like there is one buyer for every five available properties. I’m seeing up to 150 bps of cap rate relaxation on properties we are putting under contract today vs where those same properties would trade a year ago. STNL properties are selling now at prices I haven't seen in five years. And the competition for these deals is surprisingly low.
The greatest transfer of wealth
Over the next two decades, over $30 trillion in wealth is going to change hands as boomers age out and begin to sell businesses and real estate. Much of this wealth is held in real estate and will be sold because the management is too burdensome for aging landlords or as business-owners retire and sell business-use real estate assets. 1031 exchanges are the perfect vehicle for these owners to save up to 41% in taxes in some cases, all while reinvesting 100% of that equity into stable STNL properties with zero management responsibilities.
Single tenant net lease properties are by far the most popular exchange asset for investors due to their low maintenance, stable monthly income, high-credit tenants and long-term leases. We surveyed 165,000 STNL properties in Costar and found that 66% are owned by private investors—many of whom purchased through a 1031 exchange. This number will increase over the next 20 years.
Swap ‘til you drop
This cheeky expression is one of the most popular reasons that investors do a 1031 exchange. What this means is that owners can do as many 1031 exchanges as they would like in their lifetime, deferring 100% of their taxes each time. Unless they sell and recognize the gain on the sale, they will never have to pay those taxes. When they pass, their heirs can inherit that real estate and receive a step up in bases. So, if they decided to sell as soon as they take ownership, their taxable basis in the property will have reset to fair market value at the time of the devisor’s death.
This is why we call STNL properties ‘last mile properties’, because they are often the last property an owner will purchase with the sole objective being to preserve their equity, provide reliable cash flow and give their heirs a property with no management responsibilities once they pass on. Owners want to leave their kids assets, not jobs. Inheriting a multifamily property is inheriting a job. Inheriting a CVS or a 7 Eleven is inheriting a professionally operated and managed property with the capacity to continue delivering passive income for many years.
Is now the right time to sell?
Some owners feel that they missed the boat, and are coming to terms with the fact that their assets are worth 20% less than they were a year ago in some cases. They want to take advantage of an exchange but feel they are leaving money on the table.
This graph provided by Green Street shows the CPPI index of property values across the economy from 1998 to 2022. It’s important for investors to understand that if they are doing a 1031 exchange from one property to another, both their downleg property and the future upleg property are similarly affected by macroeconomic conditions. If you could have sold your property in January of 2022 for $5 million and now your property is only worth $4 million, you actually aren't losing anything because your exchange property has likely “decreased” in value by that same margin, yet the cash flow remains the same. The same would be true if you sold your current property at a 10% premium and exchanged it into a property that had also increased by 10% due to the market conditions.
Landan Dory is the Senior Vice President of Investments at Partners Commercial Real Estate based in Austin Texas. Landan’s team has conducted dozens of 1031 exchanges totaling well over $100m in recent years. Partners is a nationally recognized and Inc. 5000 full-service real estate firm headquartered in Houston.