By Austin Bowlin, CPA, Partner at Real Estate Transition Solutions
Owning investment real estate can be an effective way to build wealth and create financial security. Done properly, it can even generate stable, predictable income without significant management responsibility. However, often property owners need to rebalance their investments to achieve their objectives.
Selling investment real estate to acquire different properties better suited to meet an investor’s objectives sounds like a great idea until the taxes due upon the sale are considered. Unfortunately, the tax rate applied to sales proceeds can be as high as 42.1% at the Federal level, plus state income tax of up to 13.3%. However, one way to reposition real estate investments without taking a hefty haircut due to taxes is the strategic use of a 1031 Exchange. By performing a 1031 Exchange, property owners can sell investment property without paying capital gains tax or depreciation recapture tax, provided the sales proceeds are reinvested into “like-kind” investment real estate of equal or greater value and the conditions of the IRS tax code are followed.
The Ways to Upgrade Your Real Estate Game
Although tax deferral is a key benefit of a 1031 Exchange, it is not the only advantage that appeals to property owners. A 1031 Exchange can also serve to “upgrade” a real estate investment, so it meets the owner’s objectives, whether that be larger properties, better locations, newer construction, higher income, reduced risk, or any other goals an owner may have. Below are seven ways the owners of a single investment property can upgrade their real estate investment utilizing a 1031 Exchange:
- Exchange the Current Property With a More Favorable Property Type. A 1031 Exchange enables investors to expand their real estate portfolio into nearly every property type and even different ownership structures allowing for fractional ownership of large income-producing “institutional” investment property. Changing property types may make sense for an owner. For example, an investor experiencing challenges with their retail property due to the impact of e-commerce may prefer to invest in apartment buildings in a market with strong population growth. Alternatively, an investor seeking retirement income may sell and exchange an appreciation-focused multifamily property and exchange it into a different property type with higher cash flow.
- Change the Current Location for a More Favorable Location. The location of a rental property can significantly impact its value, cash flow, and appreciation potential. A 1031 Exchange allows investors to reinvest in real estate with more favorable locations, such as states with lower taxes, accelerating growth, and more favorable landlord-tenant laws.
- Increase the Capital Reinvested Back Into the Next Property. 1031 Exchanges offer investors the opportunity to retain all of the net proceeds from the sale of their relinquished property to reinvest in new property. This deferred tax can be viewed as an interest-free loan from the government, allowing for more significant investment in property and the potential for increased cash flow and appreciation.
- Improve Monthly Income Potential and Returns. As a wealth-building tool, a 1031 Exchange gives investors access to their property’s appreciation to increase buying power without a tax penalty. Armed with more buying power, investors can acquire properties focused on delivering income that is not only higher but passive as well. Additionally, preserving all the net sales proceeds allows for higher-value properties to be acquired. The ability to defer capital gains tax over a lifetime of real estate transactions enables you to methodically build wealth for yourself and pass on that wealth to your heirs.
- Reduce Risk on Proceeds Reinvested Into Real Estate. Due to high entry price points for real estate investing, investors typically concentrate a large portion of their net worth into one or two properties that are often in the same city or town and are the same property type. A 1031 Exchange into Delaware Statutory Trust (DST) real estate allows investors to diversify their investments into several DST properties, property types, and geographic locations.
- Reduce Taxes and Hassles for Estate Beneficiaries. By utilizing 1031 Exchanges and deferring capital gains tax until an owner passes away, investors can eliminate the deferred tax for their beneficiaries, enhancing the value of their investment for future generations. Upon the passing of an owner, the Internal Revenue Service (IRS) eliminates capital gains, depreciation recapture, and net investment income tax, a process known as a “step-up in basis.” In “community property” states, a surviving spouse is entitled to a full step-up in basis to the fair market value of the properties. Meaning the property could be sold the day after the step-up was received and pay none of the aforementioned taxes.
- Reduce the Time and Investment in Property Management. A 1031 Exchange provides real estate investors with the opportunity to transition out of actively managed properties and into passive investment options, including institutional-quality DST real estate with highly experienced, professional institutional management teams.
Understanding the Risks: The Disadvantages of a 1031 Exchange
As with any investment strategy, it is important to understand the potential risks involved. Real estate is an inherently illiquid asset class and ensuring that it is suitable for an investor’s financial position and objectives is important. One key consideration is liquidity – investors must have enough liquid assets to cover significant expenses, such as medical bills. However, there are ways to address this, such as refinancing a property or purchasing insurance.
Another potential disadvantage of a 1031 Exchange is the complexity of the process. If not executed properly, it can be costly. Therefore, working with a reputable 1031 Exchange company, a qualified intermediary, knowledgeable tax counsel, and a financial advisor and estate planning attorney is essential. At Real Estate Transition Solutions, we work with our clients and their advisors to ensure that all parties are familiar with the rules surrounding exchanges, all relevant risks are discussed, and the transaction is executed correctly.
Find Out if a Tax-Deferred 1031 Exchange is Right for You
Selling investment property with a 1031 Exchange has become a widely utilized tax avoidance strategy among income property investors. According to data from the IRS, during the ten years between 2004 and 2013, approximately $1.3 trillion of property was exchanged in over 2.9 million transactions. The popularity of 1031 Exchanges often increases during a strong economy as owners take advantage of an appreciated real estate market.
Tax-deferred exchanges offer a flexible solution for real estate investors seeking to align their investments with their financial and lifestyle objectives. For investment property owners looking to reduce active management, increase income, or eliminate tax for beneficiaries, the versatility of a 1031 Exchange can be a valuable tool for maximizing real estate investments.
Understanding the strengths and risks of 1031 Exchange options, locations, market conditions, and how they can be combined to achieve investment goals is a key focus of our firm. If you plan to sell your investment property and are interested in learning more about 1031 Exchange options, contact Real Estate Transition Solutions (RETS) to speak with a licensed 1031 Exchange Advisor. We offer complimentary consultations that can be done over the phone, via video conference, or in person at one of our offices. To schedule your consultation, call (866) 352-3354 or visit us at re-transition.com/aagla.
As Chief Exchange Strategist, Austin Bowlin leads the firm’s team of licensed 1031 Exchange advisors & analysts and provides consultation on tax liability, deferral strategies, legal entity structuring, co-ownership arrangements, 1031 replacement property options, and Delaware Statutory Trust investments. Real Estate Transition Solutions (RETS) is a consulting firm that has been specializing in tax-deferred 1031 Exchange strategies and Delaware Statutory Trust investment property for over 26 years. To learn more about 1031 Exchanges and Real Estate Transition Solutions, visit re-transition.com/aagla or call us at (866) 352-3354.
The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Such offers are only made through the sponsor’s Private Placement Memorandum (PPM), which is solely available to accredited investors and accredited entities. Examples are for illustrative purposes and not representative of future results. There are risks associated with investing in real estate properties, including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies, and illiquidity. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your situation. Delaware Statutory Trust 1031 Exchange (DST) properties are only available to accredited investors (generally described as having a net worth of over $1 million exclusive of primary residence) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your Certified Public Accountant and Attorney. Securities are offered through Aurora Securities, Inc. (ASI), a member of FINRA/SIPC. Advisory services are offered through Secure Asset Management, LLC (SAM), a registered investment advisor. ASI and SAM are affiliated companies. Real Estate Transition Solutions (RETS) is independent of ASI and SAM.