The 1031 Exchange is an often-underutilized section of the tax code. It allows investors to sell one property and use the profits to purchase another “like-kind” property, initially tax-free. Using this method, commercial real estate investors can indefinitely defer capital gains taxes, creating a snowball of profit that benefits both the investor and their heirs. What’s more, a 1031 Exchange can protect your assets by deferring tax penalties on depreciation recapture.
If you’re a real estate investor – whether in residential or commercial properties – we’re here to help you learn more about the 1031 Exchange timeline, rules, and potential benefits. We’ll also compare and contrast the 1031 Exchange method to Opportunity Fund Investments. Using this information, you can make the most well-informed decisions to expand your portfolio and increase your assets successfully.
When you’re ready to start either a 1031 Exchange or invest in an Opportunity Zone, the expert real estate professionals at CXRE are here to help you navigate the deal. Our experienced Houston commercial real estate agents can help you identify, negotiate, and close on like-kind properties quickly, protecting your assets and effectively deferring your tax burden.
Please note that we are not licensed attorneys or tax professionals, and this article should not be considered legal advice. For detailed information about the tax implications or other questions about a 1031 Exchange, contact a Certified Public Accountant (CPA) or a licensed real estate attorney.
- Terms to Know: 1031 Exchange and Opportunity Fund Investment
- What is a 1031 Exchange?
- History of the 1031 Exchange
- A Brief Overview of the 1031 Exchange Timeline
- The Fine Print: 1031 Exchange Rules
- Identify Like-Kind Property
- Appoint a Qualified Intermediary
- The 45-Day Identification Period
- Close on the Replacement Property Within 180 Days
- The Title Must Be in the Same Name
- Reinvest Equal or Greater Amount
- 1031 Reverse Exchanges
- Risks and Benefits of a 1031 Exchange
- Benefits of a 1031 Exchange
- Risks and Disadvantages of a 1031 Exchange
- Fees Associated with a 1031 Exchange
- Other Real Estate Investment Strategies: What is an Opportunity Investment Fund?
- Comparing 1031 Exchanges and Opportunity Investment Funds
- Comparing the 1031 Exchange and Opportunity Zone Investments
- How CXRE can help with 1031 Exchanges and Opportunity Investment Funds
- What types of properties are eligible for a 1031 Exchange?
- How can I find out if my property is eligible for a 1031 Exchange?
- Should I sell my property first, before I have a “like-kind” property chosen?
- What is considered a “like-kind” property?
- What happens if I cannot meet the 1031 Exchange Timeline?
- I found a property I want to purchase. Can I buy a replacement property before selling my original asset?
- Do I need to live in an opportunity zone to invest in one?
Terms to Know: 1031 Exchange and Opportunity Fund Investment
Boot: Refers to the non-like-kind property received in a 1031 Exchange. Any cash, non-qualified properties, debt relief, or property intended for private use cannot be claimed under a 1031 Exchange. In these instances, the purchaser must pay applicable taxes on the boot.
Depreciation Recapture: The taxes due on a property that has previously been used by the owner to offset income taxation. Typically, real estate investors will claim depreciation on annual income taxes to reduce their tax burden. When a property is sold, the IRS wants its share of those taxes back. So, any profits will be subjected to depreciation recapture. (Owners can defer these taxes under a 1031 Exchange).
Exchange Period: The time between closing on a relinquished property and closing on a replacement property. In a 1031 Exchange, an investor has 180 days to complete the exchange.
Like-Kind Properties: Investors can only apply a 1031 Exchange to what the IRS defines as “like-kind” properties. Under the Tax Code, like-kind properties are any real properties that are similar in type and investment scope. All assets involved in the exchange must be within the United States and must be rental or business properties. Read below for more information about what is – and is not – considered like-kind property.
Opportunity Zones: Distressed or low-income areas throughout the U.S. where investors can receive tax deferments for building commercial real estate or multifamily properties. These zones are identified by local government officials. Tax incentives encourage investors to build in these areas, therefore increasing productivity, economic growth, and quality of life.
Qualified Intermediary: An independent third party who works with an investor to legally complete a 1031 Exchange as required by law.
Reverse Exchange: Tax-deferred commercial real estate investment strategy by which an investor purchases a replacement property first, and a relinquished property identified later.
Relinquished Property: The property currently owned by an investor, which is sold to purchase a new asset under the 1031 Exchange.
Replacement Property: The property that will be purchased by an investor under the 1031 Exchange using profit from the sale of the relinquished property.
Tax-Exempt versus Tax-Deferred: While some real estate professionals talk about 1031 Exchanges being “tax-free” or “tax-exempt,” that’s not the case. In a 1031 Exchange, an investor is merely deferring taxes. Should the investor sell a property without engaging in a like-kind exchange, he or she would ultimately have to pay the capital gains taxes or depreciation recapture on that property.
What is a 1031 Exchange?
The 1031 Exchange is an IRS Tax Code dating back to 1921. This code allows real estate investors to sell existing real estate assets and then roll those profits into new properties. The investor does not have to pay capital gains taxes or depreciation recapture taxes under the 1031 Exchange.
At its core, the 1031 Exchange gives investors a means to build long-term wealth without hefty tax penalties.
Many experts talk about 1031 Exchanges as though they are a “tax-free” or “tax-exempt” means of investing. However, this code is technically a “tax-deferred” method. If the property owner decides to sell an asset without rolling the profits into a like-kind property, he or she would still be responsible for any capital gains taxes on that property. There are ways to avoid capital gains taxes altogether, which we discuss below.
This tax code encourages economic growth and reinvestment. Property owners can sell real estate and move the profits to an intermediary account approved under the law. Then, investors identify a replacement property that is “like-kind” or similar in scope and use. Finally, using funds from the original sale towards the new asset, an investor can purchase the new property without paying capital gains taxes.
History of the 1031 Exchange
Savvy real estate investors have been using the 1031 Exchange to build long-term wealth for decades. In 1921, Congress enacted the like-kind exchange statute, called the Revenue Act. This law protected real estate investors from unfair taxation. More than that, though, it encouraged continued real estate investment, which in turn would help economic growth.
In 1954, Congress updated the Revenue Act with Amendment 1031 of the IRS Tax Code (hence the name we use today). This amendment built much of the foundation on which today’s tax-deferred real estate deals still stand. In 1991, Congress added more precise definitions to the 1031 Exchange, further narrowing and guiding the program. Finally, in 2018, Congress passed the Tax Cuts and Jobs Act designed to stimulate economic growth through investment. This act further added to the rules of a 1031 Exchange.
Today, both residential and commercial real estate investors use the 1031 Exchange to roll profits into new investments, building long-term wealth and expanding real estate portfolios.
A Brief Overview of the 1031 Exchange Timeline
While the 1031 Exchange may seem convoluted and complicated, it’s a relatively simple idea. For instance, let’s say you own a multifamily property – a residential duplex – which you originally purchased for $300,000. Now, the estimated value is $400,000. If you sell the property using traditional methods and transfer your profits to a personal account, you will be responsible for paying capital gains taxes on the remaining profits.
However, if you choose to do a 1031 Exchange instead, you can put the profits into a qualified intermediary’s account, who will temporarily hold those profits for you. Then, you’ll proceed with the exchange process, eventually rolling the profits from the relinquished property into the purchase of the replacement property.
Here’s how the 1031 Exchange timeline works (we’ll go into these steps in more detail later):
- List the relinquished property for sale.
- Identify a qualified intermediary who can help you through the 1031 Exchange process.
- Upon the sale of the relinquished property, all profits enter into the intermediary’s account.
- Identify a like-kind replacement property within 45 days of closing on the relinquished property.
- Close on the replacement property within 180 days, using the funds from the relinquished property towards the purchase.
- Enjoy the tax-deferred growth of your new asset.
While there are, of course, more detailed steps than those above, this is the general timeline. Essentially, a 1031 Exchange rolls profit and principle from one property into the purchase of another, via an intermediary.
The most important thing to note is that a like-kind property must be under contract within 45 days of closing on the relinquished property, and you must close on the replacement property within 180 days. If you do not meet these deadlines, you will still be responsible for paying capital gains taxes on your profits.
The Fine Print: 1031 Exchange Rules
While the idea behind the 1031 Exchange is relatively simple, there are specific guidelines investors must follow. Failure to adhere to these guidelines could negate the exchange, leaving the investor liable for all taxes owed on a relinquished property. For more detailed information, consult with your CPA or real estate attorney.
Identify Like-Kind Property
While some investors wait until a relinquished property is under contract to take this step, many believe it wise to have a replacement property identified before selling a current asset. This way, you have a better chance of adhering to the timeline required by the IRS Tax Code.
A “like-kind” property is defined as two assets considered to be the same type, must be located within the United States, and must be used as rental or income-producing properties. Under the 1031 Exchange tax code, residential properties not used to producing income are not eligible.
As an example, selling a duplex to purchase another multifamily property, such as an apartment building, would be considered a “like-kind exchange” under the law. Selling a single-family rental property and rolling those profits into a 1031 Exchange for a duplex unit would also be acceptable. So would selling a warehouse to purchase an industrial complex.
In fact, like-kind properties refer more to the type of investment rather than the physical structure. To that end, investors can exchange nearly any property that will produce regular income for another. A duplex for an office building. An office building for an apartment. The opportunities for advancement are boundless.
Property Type vs. Property Value
Investors must consider not only the property type but also the property value. A replacement property or properties must be worth the same or more than the relinquished property to be eligible. Investors can also choose to use profits from one relinquished property, and then invest in two or more replacement properties. As long as the total of all assets is equal to or greater than the initial property, the investor may use a 1031 Exchange.
For example, let’s say you own an apartment complex worth $1 million. If you want to sell that property under a 1031 exchange, you’ll have to purchase a replacement property worth at least $1 million. So, you identify a multifamily complex, but it’s worth only $750,000. However, you also find a duplex unit worth $300,000. Since the combined totals of those two properties are more than the $1 million of the relinquished property, you could use a 1031 Exchange for these transactions.
What Is Considered a “Like-Kind” Property?
Under the current IRS tax code, properties are like-kind if they are of the same type, even if they are of a different grade or quality. They are also like-kind regardless of improvements or location. For instance, a renovated apartment complex and a run-down apartment complex are considered like-kind, because they are the same type. Of course, the replacement property or properties must be worth more than the relinquished property, so that must also factor into a 1031 Exchange decision.
Types of Properties that Qualify for a 1031 Exchange
Any real property qualifies for a 1031 Exchange if exchanged for a property of a similar type. Under the rules of the Exchange, both the relinquished property and the replacement property must be income-producing rental properties. Assets purchased solely for resale purposes (such as a fix-and-flip) do not qualify for a 1031 Exchange.
Eligible properties include, but are not limited to:
- Single-family homes used as a rental property
- Multi-family residences: duplexes, townhomes, or apartment buildings
- Vacant land
- Undeveloped land
- Retail buildings
- Office space
- Industrial properties or warehouses
- Self-storage facilities
Properties Not Eligible for a 1031 Exchange
As mentioned above, not all assets qualify for a like-kind property exchange. Assets purchased for resale purposes, like a home renovation project, cannot benefit from a 1031 Exchange.
The following property types are generally excluded from the tax-deferment program:
- Personal residences, unless used as a rental property or a portion of the residence is used as a business.
- Stocks currently in trade
- Vacation homes
- Developed lots
- Partnership interests
- Intangible assets
- Artwork or other collectibles
- Patents or intellectual property
Finding a Replacement Property
How can you find the ideal commercial real estate property for your portfolio? Depending on your location, you should contact an experienced CRE brokerage firm. For investors seeking commercial real estate in Houston or other Texas markets, CXRE is the leading brokerage firm, with over 20 years of CRE brokerage experience.
Our expert brokers can help you find a property that meets your needs and guide you through the 1031 Exchange process. Give us a call today; our knowledgeable, capable team will help you find the perfect replacement property.
Appoint a Qualified Intermediary
Before listing your current property or negotiating a deal on a replacement property, you must identify a qualified 1031 Exchange Intermediary. The Qualified Intermediary (QI) will sell the relinquished property on your behalf. Funds from this sale go into a neutral escrow account. Once you identify a replacement property, the QI will work to file the correct 1031 Exchange paperwork and will buy the replacement asset on your behalf. Finally, the QI will transfer the new asset into your name.
Who Can Be a Qualified Intermediary?
While tax code can be vague about some portions of the 1031 Exchange, it’s crystal clear about who can – and cannot – act as an intermediary. For instance, you cannot act as your own intermediary. Nor can a parent, sibling, or your children.
The 1031 Tax Code also prohibits any agent working for you to act as a QI. Therefore, you cannot have your CPA, tax attorney, real estate agent, or another professional working for you act as your intermediary. The goal is to create a non-biased, independent relationship between the QI and the investor.
So who can be a QI? According to the IRS, anyone who is not on this list of disqualified persons may act as a QI. However, investors should find and hire a knowledgeable, experienced intermediary who can accurately complete the exchange.
Where to Find a 1031 Intermediary
While you cannot use your own real estate agent, financial planner, CPA, or tax attorney as your QI, you can certainly ask them for recommendations. Each of these professionals can likely connect you with experienced professional contacts who are well-versed in the 1031 Exchange process. Your title company or mortgage broker may also have recommendations for a third-party intermediary.
The 45-Day Identification Period
Now that you’ve identified a replacement property and found a reputable intermediary, it’s time to get your current asset listed on the market. The expert brokers at CXRE can help you list your property and will work hard to get it under contract in the least amount of time possible.
Once you close on the relinquished property, all profits enter into an escrow account via the Qualified Intermediary. You now have 45 days to officially identify a replacement property.
Why Identify a Replacement Property Before Selling
Some investors wait until after the relinquished property has sold to look for a replacement. However, many experts recommend identifying potential replacements long before closing day on the previous asset. That’s because the 45-day identification period can cause stress and impulse decisions for investors who wait.
Let’s say you do not identify a replacement property before selling your relinquished asset. Now, on the day of closing, the clock begins counting down on the search for a replacement. If you don’t identify a replacement property within those 45 days, the funds from the sale will move from escrow to your personal account. And if that happens, you’ll be responsible for all capital gains taxes on the sale of your relinquished property.
If you’ve waited to identify a property, you’re now under pressure to find something – anything – that meets the 1031 Exchange standards. As such, you might end up with a property that doesn’t meet your criteria, an asset in an undesirable location, or a property that needs thousands of dollars in renovations.
However, if you identify one or several potential replacement properties before selling your current asset, you’ll have more time to identify properties that work with your portfolio. You’ll also have time for more effective negotiations, free of stressful time constraints.
What it Means to “Identify a Replacement Property”
Under the 1031 Tax Code, investors must “identify” a replacement property within the 45-day window. The law allows an investor to give an “unambiguous description” of up to three potential replacement properties that are in like-kind to the relinquished property. Investors must then report the prospective property or properties in writing to the Qualified Intermediary.
Close on the Replacement Property Within 180 Days
Upon transfer of the relinquished property to the new owner(s), you will have 180 days to close on a replacement property. We should note that this timeframe includes the 45-day identification period and is not in addition to these 45 days.
Improvements to Replacement Property
If the replacement property requires a build-out, renovations, or improvements, and you want to include those costs in the 1031 Exchange, all construction must be completed by the time the deal closes. That is, renovations and repairs must not take longer than 180 days after closing on the relinquished property. Construction costs incurred after 180 days will be the personal responsibility of the owner and may not fall under the 1031 Exchange.
Should the deal on the replacement property fail to close within 180 days, all funds in escrow will transfer to the investor’s bank account. At that time, the investor will have to pay taxes on the relinquished property’s profits.
The Title Must Be in the Same Name
Under the rules of the Tax Code, the title of the relinquished property and the title for the replacement property must match exactly. If a trust or corporation is on title of the old asset, that same trust or corporation must be on the title of the new property. If a married couple purchased the relinquished property, both must also be on the title of the replacement property.
Solutions to 1031 Exchange Title Issues
Sometimes, not all parties involved in an original investment want to take part in the 1031 Exchange. However, depending on the asset holders, this could negate a like-kind exchange.
For example, if shareholders or members of an LLC want to sell their interest before the 1031 Exchange takes place, the exchange might no longer be allowed under the current IRS tax code. Instead, the owner must liquidate the original asset, and all members will receive deeds; the initial partnership would then be negated. Consult an experienced real estate attorney to ensure such a transaction would qualify under the 1031 Tax Code.
Similarly, individuals who purchase an original property, but then want to conduct a 1031 Exchange with a partner or spouse, cannot do so under the current law. Instead, the original owner must complete the 1031 Exchange, then complete a Quit Claim, placing the interests in the names of both partners.
Reinvest Equal or Greater Amount
To qualify for full tax deferment, the replacement property or properties, including the debt and equity, must be equal to or greater than the amount of the relinquished property. However, we should note that investors may deduct closing costs and other sale-related expenses from this total.
Example of Value Comparisons
Let’s say your relinquished property has a value of $1 million. However, you still have a $250,000 mortgage on the property. The replacement property, therefore, would need to be worth at least $1 million, and you will have to take out at least a $250,000 mortgage on the new asset.
Under the 1031 Tax Code, investors can take profits from one property and invest in two or more replacement properties. As long as the combined value of the new assets is equal to or greater than the relinquished property, the investor can claim tax deferment benefits under a 1031 Exchange.
Including Closing and Renovation Costs in Property Value
All cash profits must be invested into a new property to qualify for tax deferment. However, closing costs and renovation or construction costs on the replacement property factor into this figure. But all renovations must be completed within the 180-day exchange period. So, given our previous example, if an investor finds a property worth only $900,000, but the total cost after closing and renovations soars to $1.2 million, that property would still be eligible for the 1031 Exchange.
In this example, improvement costs count toward the overall value of the replacement property, but do not subtract from the debt burden. That is, regardless of the total value of the replacement property and the improvement costs, the investor must still take out an equal debt amount. If we use the example above, the investor will still be required to take out a $250,000 loan on the replacement asset, no matter the improvement costs.
Even in a 1031 Exchange, you may end up paying capital gains taxes. If the actual value of a new property is less than that of the sold property, the difference is known as a “cash boot.” The boot amount is considered income, and you will be responsible for all taxes incurred.
Secondly, non-like-kind assets received from the replacement property will also be subject to applicable taxes. Examples of non-like-kind assets include cash or cash-equivalent earnings, debt relief, stocks, or non-real estate items like artwork, certain machinery, or other components. Each of these assets will be considered boot and will be subject to taxation.
In other instances, the buyer may require cash for another transaction or other purpose. While there is no rule against taking cash from the sale of the relinquished property, this cash will still be subject to capital gains tax under the law. The investor should determine the amount of cash needed before closing on the relinquished property, and this amount should be moved directly into his or her personal account. The remaining profits from the sale of the property will then transfer to a QI.
1031 Reverse Exchanges
In a 1031 Reverse Exchange, an investor identifies and purchases a replacement property before selling off a current property.
In a 1031 Reverse Exchange, the same timeline applies. After purchasing a replacement property, the exchanger must identify a current asset (the property to be relinquished) within 45 days of the purchase and the deal completed within 180 days of the original purchase.
Just as with a 1031 Exchange, a reverse exchange requires funds to transfer through a Qualified Intermediary.
However, a reverse exchange requires particular consideration because investors must provide funding upfront for the replacement property. While the investor can still defer capital gains taxes from the sale of the relinquished property by reinvesting profits into a replacement property, this transaction happens after the sale of the original asset. Therefore, investors must have adequate funding to purchase a replacement property before the exchange.
Why Consider a 1031 Reverse Exchange?
There are many reasons to consider a 1031 Reverse Exchange over a traditional like-kind exchange. For instance, you might stumble across an investment opportunity that will make an excellent addition to your portfolio. Rather than waiting for your relinquished property to sell, and risk losing the deal, you can purchase the replacement property upfront. This way, you’re guaranteed the ideal replacement property, and the only condition is choosing a current asset to sell.
With a traditional 1031 Exchange, there is pressure to identify a replacement property within the 45-day timeframe. Sometimes, investors end up purchasing a property that might not meet their specific needs, but they’re forced to close on the property anyway to gain the tax deferment benefits. With a 1031 Reverse Exchange, investors can find and purchase the ideal property first and then sell off current assets later.
Similarly, you might enter into a 1031 Exchange, but have the sale of your relinquished property fall through. In that instance, a Reverse Exchange allows you to still purchase the replacement property you’ve already identified, and then have 180 days to close the deal on your relinquished asset.
Additional Reverse Exchange Considerations
There are unique rules and regulations pertaining to a Reverse Exchange. Due to the complexity of these deals, you can expect to incur more fees on a Reverse Exchange. Contact a real estate attorney or CPA for the most up-to-date details.
Risks and Benefits of a 1031 Exchange
Savvy investors have used 1031 Exchanges for years, deferring capital gains taxes for many decades. It’s a great way to build tax-free, long-term wealth. However, you probably won’t be surprised to learn that 1031 Exchanges also come with inherent risks.
Benefits of a 1031 Exchange
Most investors would say the benefits of a 1031 Exchange far outweigh the disadvantages.
1. Tax Deferral
Perhaps the most apparent advantage of a 1031 Exchange is the investor’s ability to defer capital gains taxes. On a traditional real estate sale, the owner would have to pay taxes on any gains realized (capital gains) on the property, calculated based on the owner’s tax rate. Of course, many other factors play into these figures, such as costs associated with closing, improvement costs, and others, so consult your tax professional for more information.
Here’s the basic idea: In a traditional real estate sale, if you purchased an investment property for $650,000, but sell it for $680,000, you will owe taxes on the $30,000. However, if you set up the sale as a 1031 Exchange through a Qualified Intermediary, that $30,000 in gains will enter into escrow for the purchase of a new investment property. Under the rules of the Tax Code, taxes on the $30,000 are deferred.
If you choose to liquidate all properties at some point, you will owe taxes on these gains. However, as long as you continue to use a 1031 Exchange to sell and buy investment assets, these taxes will be deferred.
2. Portfolio Expansion
1031 Exchanges allow real estate investors to continually invest in new assets. Some sell high-value properties in large cities, for example, and purchase many assets in more affordable areas. This strategy allows investors to gain more properties, earn more cash flow, and build thriving and diverse real estate portfolios. Many investors have made millions using 1031 Exchanges to buy and sell income-producing real estate consistently.
Plus, the newest additions to the 1031 tax code gives real estate investors more options for diversification. That is, “like-kind” doesn’t just mean selling a single-family property and acquiring another. Instead, “like-kind” could apply to a variety of investment properties. Therefore, you might sell a single-family rental property and roll those profits into a small retail center. Or, you might purchase several smaller multifamily units. Either way, you’re diversifying your real estate portfolio and increasing both your monthly income and your long-term net worth.
3. Enter New Real Estate Markets
We should note that 1031 Exchanges apply to any city, county, or state in the nation. Therefore, you can sell one property in Boston, and using a 1031 Exchange, purchase other investment properties in Raleigh. Or Houston. Or Sacramento.
Using this method, you can create a portfolio of diverse properties in diverse markets. And by doing so, you’ll protect your assets should one market see a downturn.
4. Trade Up
Think of a 1031 Exchange as your method for climbing the proverbial commercial real estate ladder, specifically for those new to the commercial real estate game.
Essentially, the process is akin to a real estate snowball effect. When you sell one property, you can use a 1031 Exchange to purchase a more valuable asset or multiple income properties. In several years, you can sell those assets, and using a 1031 Exchange, acquire even more valuable properties, and so on.
Eventually, you’ll have an entire catalog of valuable properties, all without paying a penny in capital gains taxes.
5. Consolidate Management Costs
If you’re an investor who owns several scattered rental properties across a large geographic area, you’re likely paying multiple management companies every month. Instead, many investors sell single-tenant properties, like houses or duplexes, and roll those profits into one larger multifamily property, like an apartment complex or office building.
By consolidating your assets into one more substantial property, you can hire one singular management company, thus lowering your overall management and maintenance costs.
Risks and Disadvantages of a 1031 Exchange
As with any investments, there are risks and potential disadvantages of 1031 Exchanges.
1. You’re on a Deadline
To take advantage of the tax benefits, you’ll have to identify a replacement property within a 45-day window. You’ll have to close on that replacement property within 180 days. Sometimes, those tight deadlines cause investors to purchase assets they would normally not consider, simply because they must buy something.
If you fail to identify and close on a replacement property within that timeline, the Qualified Intermediary will return the profits from your relinquished property, and you’ll be responsible for capital gains taxes on that property.
All that said, if you’re not ready or able to find a new property quickly, a 1031 Exchange might not be your best option.
2. You’ll Still Pay Taxes on “Boot”
“Boot” is the non-real estate property that accompanies a deal. It can be anything from debt relief to cash for a down payment to artwork or furniture inside the new property. Anything not considered like-kind property is considered boot, and you’ll have to pay taxes on all of it. So, consider everything involved in the deal, and make sure you understand your tax burden.
If you’re unsure what is real property and what will be taxed as boot, check with a tax or real estate professional.
3. Gains Are Deferred…But So Are Losses
A 1031 Exchange allows you to defer the taxes on capital gains, but it also defers your losses. Therefore, you won’t be able to claim those losses in market downturn years, which could hurt you in the end. Before entering into a 1031 Exchange, speak with a CPA or tax attorney who is knowledgeable about the program. Getting expert advice about all your options is key to your financial success.
4. Taxes Might Rise in the Future
While no one can predict the future, it’s entirely possible the government might raise capital gains tax rates in the future. Therefore, when you’re ready to liquidate all your assets for retirement, you may be facing significantly higher tax rates than you would have if you had sold the property outright in the first place. Of course, tax rates could conceivably drop as well, so it’s all a gamble. Still, it’s worth considering the possibility that tax rates will change by the time you’re ready to sell.
5. Taxes Are Deferred, But Not Forgotten
Speaking of capital gains tax rates, it’s important to remember that a 1031 Exchange does not eliminate taxes. Instead, it merely defers them. Therefore, once you’re ready to retire, say, or liquidate all your assets for another reason, you’ll owe taxes on any realized gains at that time. Essentially, a 1031 Exchange acts as an “IOU” to the IRS. When you cash in on those assets, you just pay back all the taxes you’ve deferred over the years. And since you can use 1031 Exchanges multiple times over the course of your lifetime, those end taxes could be substantial.
There’s only one instance when the IRS will forgive all capital gains taxes on a property; when the titleholder dies. If you acquire a vast portfolio, deferring taxes through the 1031 Tax Code, those properties will pass to your heirs at the time of your death. Therefore, the ultimate strategy for a 1031 Exchange is to create an extensive portfolio of income-producing properties during your lifetime and hold them until your life is over. Then, they will become the inheritance for your next of kin.
It may seem like a somewhat morbid investment strategy for some, but the “defer, defer, die” approach is the most lucrative way to leave wealth for your heirs.
Fees Associated with a 1031 Exchange
You may not have to pay capital gains taxes on a 1031 Exchange, but that doesn’t mean the process is inexpensive. There are a host of fees associated with completing a 1031 Exchange.
Fees associated with the exchange typically aren’t taxable, and therefore don’t count towards the capital gains on the relinquished property. Exchange-related fees include:
- Broker commissions
- Exchange fees
- Title insurance fees
- Expenses associated with escrow or Qualified Intermediary
- Attorney fees connected to the exchange process
Other costs are considered non-exchange fees. These expenses can be paid from the exchange funds but are often taxable. These fees include:
- Outstanding security deposits or rents
- Loan acquisition fees
- Appraisals and environmental investigations required by the lender
- Property taxes
- Insurance premiums
To ensure you’re complying with all regulations, and to understand what is and is not taxable in the like-kind exchange process, consult your tax specialist.
Other Real Estate Investment Strategies: What is an Opportunity Investment Fund?
The Tax Reform Reconciliation Act of 2017 established a new incentive program designed to help low-income areas across America. Under Internal Revenue Code Subchapter Z, investors can purchase and build commercial real estate projects in designated Opportunity Zones with tax deferral benefits.
You can find a more in-depth explanation and analysis of Opportunity Zones and Opportunity Investment Funds in this comprehensive guide.
Opportunity Investment Fund Basics
- Investors can stimulate the economy and provide affordable housing options for historically low-income neighborhoods across the country. These “Opportunity Zones” are determined by local and state governments. To qualify as an Opportunity Zone, 20% or more of the area’s population must be living at or below the poverty level, or below 80% of the median income level for the area.
- The only way to invest in an Opportunity Zone is to invest in a qualified Opportunity Fund. These funds are the vehicle through which Opportunity Zone investing takes place. These funds are set up as LLCs or partnerships and are required for investors to receive the desired tax benefits.
- Those who invest in Opportunity Investment Funds qualify for short-term tax deferral on those investments. Furthermore, long-term holdings are eligible for drastic capital gains rates and, ultimately, will report no capital gain income. After holding the property for ten years or more, the investor will not pay any taxes on the gains realized after the initial sale. In addition, the IRS forgives up to 15% of the tax burden on the initial investment as well.
- Opportunity Zone investments come in various forms: office buildings, retail centers, multifamily properties, or RV parks. Whatever the project, Opportunity Investment Funds must make “substantial improvements” to the areas or properties they purchase.
Like a 1031 Exchange, investing in Opportunity Zones must be done within a designated timeline. As is the case with a like-kind exchange, investors have 180 days to reinvest profits from the sale of one property into an Opportunity Investment Fund.
Investors must hold the property for at least ten years to realize the maximum tax benefits of the Opportunity Zone program.
For more information about investing in Opportunity Zones, check out our comprehensive online guide, or contact your local real estate tax attorney.
Comparing 1031 Exchanges and Opportunity Investment Funds
For real estate investors, both a 1031 Exchange and investing in Opportunity Zones can prove profitable strategies. And while there are some similarities between the two programs, there are also very distinct differences. Consult your CPA or tax attorney to discuss both options and to decide on the strategy that works best for your portfolio.
- Both programs allow the investor to defer capital gains taxes on the property. While the rules and regulations for each plan are unique, each program gives tax deferral incentives. If deferred indefinitely, properties purchased under a 1031 Exchange will be inherited by your heirs at the time of your death, without any tax burden whatsoever.
- Both the 1031 Exchange and Opportunity Investment Fund encourage investors to reinvest their profits back into the real estate market. Therefore, both programs help keep the market secure. In the case of Opportunity Investment Funds, investors can also help rebuild impoverished and underserved communities, giving new life to previously underdeveloped areas. In both cases, the emphasis is on economic growth, helping not just the investor, but all those involved.
- Each program allows investors to diversify their investment portfolios. By adding commercial real estate investments to a portfolio, investors can protect their funds in the event of a significant stock market crash.
The main difference between 1031 Exchanges and Opportunity Investment Funds is the way capital gains taxes are collected. With a 1031 Exchange, owners may defer the taxes owed on the sale of relinquished properties until the eventual sale of the final asset. Since there are no limits on the number of times an investor can use a 1031 Exchange, owners can continually sell assets and roll those profits into a new investment property or properties under the program.
Investing in an Opportunity Zone is a more short-term approach. After ten years, property owners can sell the property and fully realize the tax benefits. The owner will not pay any capital gains taxes on the growth realized from the date of sale, though the owner will still be responsible for a large portion of taxes on relinquished property gains.Essentially, it boils down to this: 1031 Exchanges are a long-term wealth-building strategy. In contrast, investing in Opportunity Zones is typically a 10-year commitment.
A 1031 Exchange is also known as a “like-kind” exchange because the relinquished property and the replacement property must be of similar type. The IRS defines like-kind properties as anything that is the same nature, character, or class. In most cases, any kind of real estate will be like-kind to other real estate. With a 1031 Exchange, properties may be in any area, in any city, or any state in America.
In contrast, Opportunity Investment Funds require buyers to purchase properties in designated low-income or underutilized areas. Therefore, investors are more limited in their options. However, given the large number of Opportunity Zones across the United States, interested buyers often aren’t discouraged by this requirement.
To qualify for a 1031 Exchange, funding for the replacement property must come from the sale of like-kind real estate. Financing for an Opportunity Zone investment, however, can come from any investment: real estate, stock market investments, or other sources. For this reason, Opportunity Investment Funds are a popular option with investors just entering the real estate market.
Comparing the 1031 Exchange and Opportunity Zone Investments
|Both gains and principal on a relinquished property must be reinvested into the replacement property to qualify for tax deferral.||Investors may use any portion of the gain from a replacement property or the sale of other investments to purchase a replacement property. However, only the monies used towards the purchase will be tax-deferred.|
|Only “like-kind” properties are eligible. That is, real property, land, or other real estate investments qualify for a 1031 Exchange. Stocks, intellectual property, and non-real estate items are not eligible under the like-kind exchange rules.||Investors may sell any investment and use the profits to purchase a property in a designated Opportunity Zone. Investors may sell stocks, property, or other assets and buy real estate in Opportunity Zones. However, only the capital invested is eligible for tax deferral. Gains not invested in the replacement property will still be considered taxable income.|
|There is no limit on how many times an investor may use a 1031 Exchange. Therefore, investors may defer taxes on all properties indefinitely. The owner will only pay taxes once the property sells if those funds are not rolled over into another 1031 investment.||Tax gains on the initial investment (relinquished property) are deferred up to 10 years. Depending on how long the owner holds the replacement asset, they may face a smaller tax burden upon the sale of this property. Owning an asset for seven years gives the investor a 15% reduction in their tax burden.|
Which Investment Strategy is Best?
Both a 1031 Exchange and an Opportunity Investment Fund give investors tax advantages. Depending on your overall financial goals and your current real estate portfolio, only you can determine which investment option works best for you.
While 1031 Exchanges and Opportunity Investment Funds are two separate tracks that generally cannot be combined, there are ways to roll an existing 1031 into an Opportunity Zone purchase. For example, if you’re interested in purchasing a property using an Opportunity Investment Fund, you can sell the property on which you have a 1031 tax deferment. Upon that sale, you will use those funds to purchase an Opportunity Zone property. Now, you’re under an entirely different tax structure, but you can reduce your overall tax burden by owning the property for at least seven years.
To learn more about each option, and to determine which one makes the most sense given your long-term financial goals, talk to an experienced CPA or tax attorney.
How CXRE can help with 1031 Exchanges and Opportunity Investment Funds
First, we always recommend that any investor talk with a CPA or tax attorney who is knowledgeable about 1031 Exchanges and Opportunity Investment Funds. These experts can give you the most up-to-date details regarding each investment strategy and help you find the option that works best for you and your family.
However, when the time comes to sell assets, identify replacement properties, purchase new properties, or manage your properties, CXRE can help you find real estate that meets your needs. Whether you’re looking for commercial real estate in Houston, Dallas, San Antonio, or another market, our dedicated professionals will work hard to find properties that meet your needs.
Contact us today to see how we can help you successfully navigate a 1031 Exchange or find an Opportunity Zone investment.
What types of properties are eligible for a 1031 Exchange?
Any property owned as an investment property or for business or trade exchanges is eligible. The investor’s primary residence or properties bought for the sole purpose of renovating and selling (“fix and flips”) are generally not eligible for a 1031 Exchange.
How can I find out if my property is eligible for a 1031 Exchange?
The best way to determine if your property is eligible is to contact an expert real estate attorney.
Should I sell my property first, before I have a “like-kind” property chosen?
That depends. If you have a replacement property in mind already, you can sell your relinquished property first, and then identify the replacement property or properties within the allowed timeframe. You have 45 days to formally designate a replacement property, and then 180 days to close on that property.
Your other option is to complete a “Reverse Exchange,” where you will purchase the replacement property first and then identify a current asset to sell within 45 days. This option is excellent for investors who find a replacement property unexpectedly, need to act quickly to purchase an asset, or who don’t want the stress of identifying a replacement property after selling a current asset.
What is considered a “like-kind” property?
According to the IRS, properties are considered like-kind if they’re “of the same nature or character, even if they differ in grade or quality.” Most real properties (houses, office buildings, retail centers, multifamily units, storage units, and even undeveloped property) count as like-kind properties.
What happens if I cannot meet the 1031 Exchange Timeline?
Owners must identify a replacement property within 45 days of closing on the relinquished property and close within 180 days. During that time, funds from the sale of the relinquished property are being held in escrow by a Qualified Intermediary. If the investor does not meet the timeline laid out under the 1031 Exchange law, those funds transfer to the owner’s personal account and will be subject to capital gains taxes.
I found a property I want to purchase. Can I buy a replacement property before selling my original asset?
Yes! The Reverse Exchange provision allows investors to purchase a replacement property first (through a Qualified Intermediary) and then identify a current asset to sell. Similar to the traditional 1031 Exchange timeline, owners must identify an asset to relinquish within 45 days and complete the deal within 180 days.
Do I need to live in an opportunity zone to invest in one?
No. Any investor can purchase property in an Opportunity Zone, even if they don’t live or conduct business there. To qualify for an Opportunity Zone tax deferment, owners must roll capital gains on any investment into the purchase of a property in a designated opportunity zone.