Should You Defer Real Estate Capital Gains with a 1031 Exchange?
Why might a real estate investor “swap” one property for another rather than sell? The process, which almost always involves a third party, allows investors to take advantage of Internal Revenue Code Section 1031 and defer paying taxes on capital gains. Congress may take steps to limit these “like-kind” exchanges, but they remain for now and can make for an effective tax strategy in certain circumstances.
1031 Exchange Basics
Although Section 1031 originally applied to various asset categories, the Tax Cuts and Jobs Act of 2017 limited it to real property that is held for business use or as an investment.
Because it is rare for two property owners to agree on an even swap, a qualified intermediary holds the initial sale proceeds, and later transfers those funds to the replacement property seller.
There is currently no limit on the number of times a taxpayer can make a 1031 exchange, so a business can continue rolling over its tax-deferred gains through subsequent property exchanges until it ultimately liquidates its investment. Individual taxpayers can defer gains until their death, at which time the deferred taxes are effectively erased and the property passes on to the taxpayer’s heirs with a step-up in basis.
1031 Exchange Complications
While Section 1031 applies to all types of taxpayers including individuals, corporations, and other entities, 1031 exchanges can be more difficult to manage in partnerships and other pass-through entities because the participants’ varying tax situations can prevent agreement on how much, if any, of the sale proceeds should be diverted into a 1031 exchange.
To qualify for a deferral, a 1031 exchange participant has just 45 days from the sale of the property to identify a limited number of potential replacements, and only 180 days to complete the purchase. These deadlines can put buyers at a disadvantage, forcing them to rush into a purchase to avoid losing all their accumulated tax deferrals.
1031 Exchange Strategies
To accommodate Section 1031’s rigid deadlines, some taxpayers initiate a reverse exchange, in which they purchase the replacement property before selling the original. This can be advantageous in a hot market but it poses more risk as the taxpayer must be able to fund the purchase before receiving the sales proceeds. Reverse exchanges also can incur additional transaction costs.
Rather than rushing to find a suitable replacement property within Section 1031’s time limits, many sellers instead choose to purchase a fractional interest in a property, often using a Delaware Statutory Trust (DST), an entity created specifically to hold title to investment real estate. In addition to incurring added fees, a DST investor also relinquishes significant control over the investment because the trustee ultimately decides how to manage the property, including whether and when to sell.
Alternatives to a 1031 Exchange
Beyond 1031 exchanges, there are other available strategies for deferring or reducing tax obligations from the sale of property. In an installment sale, for example, the taxpayer still pays tax on the gain, but the burden is spread out over the duration of the installment contract.
Rather than selling an investment or business property, individual taxpayers who are charitably inclined may donate it to a charitable remainder trust, naming a tax-exempt charity as the beneficiary. The trust then sells the property, reinvests the proceeds, and pays recurring income to the taxpayer until the taxpayer’s death, at which time the remaining funds are given to the charity. In exchange for the property, the donor receives a tax deduction along with a lifetime source of income.
Another option if an investor seeks to defer capital gains taxes (at least through 2026) would be reinvesting them into a Qualified Opportunity Zone Fund (QOF). The tax bill comes due in 2027, but if the QOF investment is held for five years, investors can permanently exclude 10% of the deferred gain. Holding it for 10 years will make the gains from the QOF sale tax-free. These transactions differ from 1031 exchanges in that you can defer the tax by investing only the gains from the sale, as opposed to the entirety of the proceeds.
Like so many aspects of the tax code, Section 1031’s utility depends greatly on your individual investments and strategy. Selling a business or investment property can be challenging, with many variables and alternatives to consider. Always consult with a qualified tax professional.
Real estate is subject to an especially complex section of the tax code, making proper planning crucial for your success. Dembo Jones’ real estate experts can guide your company through the required regulations and compliance issues, allowing you to focus on managing your properties. Contact us today.