Why a §1031 Exchange is Not a Real Estate Strategy
Updated: Jul 8
In real estate, investors rely on their insights to determine when an asset is a good investment. As their investing journey starts to develop, their insights grow and their actions start to evolve. What they require out of their investment changes. They may start to change asset types, amounts, etc. They may need to sell in order to buy. Some common strategies include:
1. Trading up/consolidating investments
2. Trading investments into a different geographic location
3. Changing asset classes
A §1031 exchange is a popular real estate tool to optimize these strategies. The laymen’s definition of a §1031 is transferring capital from one investment to another like-kind investment and deferring some or all of the income tax impact at the same time.
Investors need to understand that a §1031 requires some up-front planning. You must work with a team who can help you understand the definitions of “like-kind” and explain capital gain versus ordinary gain, depreciation, tax/cost basis, cash boot, and depreciation recapture. Our team has extensive modeling capabilities that help you analyze how a §1031 transaction can benefit your strategy.
The benefits of using a tool like a §1031 is that a tax deferment today can have significant financial advantages over time. Let’s look at a example to illustrate this point. Let’s assume that an investor buys an asset for $1MM and spends an additional $500K on renovations. After five years, she sells the property for $2MM. With no §1031, she will pay almost $90K in taxes. If she utilizes a §1031, the investor can defer those taxes and invest that $90K. If the $90K were to earn 8% over the next 20 years, its future value is over $400K. When the investor eventually decides to sell the property, she will owe taxes but the financial benefit of investing the deferred taxes will far outweigh the tax due (in this case she would pocket around $300K).
With a §1031, investors can trade property types and locations without an immediate income tax impact. For example, investors can move from management-intensive residential assets into commercial assets. They can sell a condo in California and use the funds to buy a higher yield property in the Midwest. Or, they can sell Kansas rental properties to buy a vacation home in Florida.
One unique way we have helped investors use a §1031 is to hedge their personal business and real estate investment risks. If you own a business and own the building you are operating in, you have doubled down on your risk. If your business fails, the investment in your building suffers also. We work with investors to decrease this risk by helping them sell their current building (while still locking in a long-term lease if desired) and then using a §1031 to invest in a separate building with third party tenants.
The downsides of using the §1031 tool include the possibility of having to purchase replacement property at above market price, the risk that the designated property falls through, and/or the lack of negotiation ability if seller knows you are pursuing a §1031. You are also constrained by having a designated timeline and incur significant transaction costs.
At SNC Group, we help investors succeed in real estate. Our modeling capabilities and insights can help you determine if your investing strategy should leverage the §1031 tool. Send us an e-mail at firstname.lastname@example.org to start discussing your strategy today.