Understanding The Benefits of a 1031 Exchange
One of the most compelling reasons to invest in real estate is the ability to defer tax on profits. A great way to do this is by utilizing the IRS 1031 exchange rules. A 1031 exchange or more correctly, a Like Kind Exchange allows for the deferral of taxation on profits from the sale of real estate. This is the case as long as such principal and profits are reinvested in another real asset:
Section 1031 (a)(1) from the IRA Code states: -- “No gain or loss shall be recognized
on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
For Example:
You purchased a mixed-use property in Brooklyn for One million dollars. 10 years later, the property is worth Two Million Dollars. Like any good property owner, you have been depreciating the asset over the 10-year hold period to offset your cash flow with losses. If you were to just sell, the profit and tax implication would look something like this:
Purchase Price: $1,000,000
Sale Price: $2,000,000
Profit: $1,000,000
Approximate Basis at Sale: $585,000
Estimated Taxes Owed (20%): ($283,000)
In the above example, instead of paying the $283,000 in tax burden, you could alternatively perform a 1031 exchange and roll over the $2,000,000 into a multifamily acquisition. By doing this you are gaining the following benefits: Through the exchange rules you are able to re-invest $2,000,000 ilo $1,617,000, putting more money to work. You now own a larger asset with greater income potential. On this new purchase you may also depreciate the asset starting from $2,000,000 further offsetting your taxable income into the future.
To take it a step further, many believe in the “swap til you drop strategy,” where you continue to buy and 1031 into larger and larger assets...continuously cash flowing your tax deferred dollars! Ultimately, when you pass away, your heir will inherit your position with a stepped-up tax basis, wiping away substantial tax implications, and creating a meaningful legacy for your family. As you can imagine, this strategy is even more powerful when you take into account leverage!
How we work with people looking to perform a 1031 exchange:
We have successfully worked clients that have owned single family rentals, multifamily, and mixed-use properties. In each case, they owned in the northeast and wanted to reinvest into the growing markets of the south. In addition to the benefit of owning in more growth-oriented markets, they also were able to own in larger, more scalable assets.
Why Now?
When it comes to whether or not to perform an exchange, we often look at return on equity. In the example above, you may be cash flowing 8-10% on the million dollars. However, if you have 2 million dollars’ worth of equity in your asset you are really just making 4-5% on your equity. Performing the 1031 exchange will allow you to really leverage the equity into a new asset where you are then cash flowing 8-10% on 2 million dollars (plus the benefit of principal pay down and appreciation.)
Another factor to closely monitor is tax law. Current presidential hopeful Joe Biden, has proposed removing the Like Kind Exchange tax strategy. If he is elected and ultimately successful, it would wipe away this significant benefit.
What you need to know?
There are clearly defined rules and parameters that must be abided by in order to complete a 1031 exchange. Most commonly (though there are a few scenarios), you will need to identify 3 target acquisitions within 45 days of closing and close on one of the 3 prospects within 6 months. Identifying promising acquisitions is what we do best. We have educated many investors on how to properly perform these exchanges and can work with your professionals to make sure it is done right. If you are thinking about doing a 1031 exchange or just want to learn more, schedule a meeting with us today!