By Dwight Kay and the Kay Properties Team
Welcome to 1031 101! If you’ve come to our metaphorical class here, you likely have a few questions. Chief among them: what is a 1031 exchange? What Qualifies for a 1031 exchange? Why should I do a 1031 exchange? What should I 1031 exchange into? Is there an option if I have a failed 1031 exchange?
WHAT IS A 1031 EXCHANGE?
A 1031 exchange is a procedure that allows the owner of investment property to sell and acquire another “like-kind” property while deferring capital gains tax. The name comes from IRS Section 1031 and has morphed into a verb in the investment real estate world — as in, “Let’s 1031 this property for that one.”
WHAT QUALIFIES FOR A 1031 EXCHANGE?
While the idea is a simple one, the execution is a bit more complex. There are very specific definitions and timeframes to which users must adhere to qualify for a 1031 exchange.
The most important thing to keep in mind just might be how to define a “like-kind” property. That doesn’t mean you must exchange one apartment complex for another; there’s actual considerable flexibility there. For instance, you can sell an apartment complex and purchase a retail building, you can sell a retail building and purchase and industrial building, you can sell an industrial building and purchase raw land, etc. However, you can’t exchange a property for a business, for example. It’s also worth noting that a 1031 exchange can only involve property held for investment, not personal use and, to maximize the benefits of a 1031 exchange, the replacement property should be of equal or greater value than the original.
What’s often forgotten in the lead-up to an investment property’s sale is how quickly the 1031 clock starts. After that sale, you have 45 days to choose aka identify a property with your qualified intermediary (the escrow like company that holds your exchange proceeds after you sell your relinquished property). From there you must close on that property within 180 days of the sale to qualify for the 1031 benefits.
WHY SHOULD I DO A 1031 EXCHANGE?
You know the saying about death and taxes? Well, at least you can defer one of those with a 1031 exchange. Typically, when you sell an investment property, you’re subject to several different taxes. But by trading one like-kind property for another via a 1031 exchange, the IRS lets you defer a considerable amount of taxes.
Without a 1031 exchange, you can be taxed at a rate of 25 percent on all depreciation recapture. Depending on your taxable income, you would owe federal capital gains tax of at least 15 percent and as high as 20%. On top of that is the state capital gains tax which is anywhere from 0-13.3%. Lastly, there is a 3.8 percent Medicare surtax as well.
WHAT SHOULD I 1031 EXCHANGE INTO?
We’ve already established that you must exchange your investment property for a like-kind property. However, there are many different options for you to execute a 1031 exchange.
The most obvious is trading one property you manage for another. An example: you sell a duplex and purchase a commercial building. In that instance, you’re maintaining your role as landlord, which comes with responsibilities such as repairing issues, dealing with individual tenants, property management, asset and property level accounting and processing rent. The role of the investor is very involved.
A slightly more passive approach is to exchange into a triple-net property. In this case, you’re leasing your property to a tenant who often agrees to pay the majority of expenses associated with the property. Which can include taxes, insurance and maintenance. But it does not mean the investor just gets to kick back. You are still often responsible for those many needs of a property — including coordinating and paying for repairs, paying property tax bills, processing invoices. The difference from a standard lease is that you are then billing the tenant for those expenses and now tasked with the fun job of tracking down the tenant and getting them to actually reimburse you for them. Our firm has owned many triple net properties over the years and we have to have full time asset management, accounting and legal teams to look after the triple net properties and run them efficiently. For an investor to think that the triple net property option is a passive endeavor is wishful thinking!
If, as an investor, you are looking for a fully passive exchange option, Delaware Statutory Trusts (DSTs) are potentially a good option. A DST is an entity that holds title to a piece of real estate and investors are able to buy in for typically 100k minimum investments. DSTs are used by investors to build a diversified* portfolio for their 1031 exchanges whereby they can, for example, on an exchange with $1,000,000 of equity purchase 5 different DSTs in 200k increments. The investor may purchase 200k in a DST that owns a long-term net leased FedEx building, 200k in a DST that owns a long-term net leased Amazon building, 200k in a debt free multifamily DST apartment building in the Nashville metro area, 200k in a DST that owns 1,000 multifamily units among 3 properties in 3 different states and lastly 200k in a DST that owns a long-term net lease industrial building.
Additionally, the trust’s sponsor is the asset manager of the property, which involves handling reimbursements from tenants and daily needs, repairing issues, processing rent and invoices, etc. This provides investors with a truly passive approach to their 1031 exchange and a change in lifestyle from the active duties of property management. DSTs are also a great backup plan to keep in mind due to the 1031 exchange’s tight timeframe. Because the trust already owns the properties, transactions can often be completed within just a few days.
IS THERE AN OPTION IF I HAVE A FAILED 1031 EXCHANGE?
If a 1031 isn’t on the table for you (for whatever reason that might be), the Tax Cuts and Jobs Act of 2007 created a new way to defer, reduce and, in some cases, eliminate long-term capital gains taxes: Opportunity zones. There are more than 8,700 qualified tracts scattered around the country. By investing your capital gains in one of those via a Qualified Opportunity Zone Fund, you will be able to defer any taxable gain until the fund is sold or Dec. 31, 2026, whichever comes first. Five years in, you receive a 10 percent step-up in tax basis with an additional 5 percent step-up after seven years. Hold the fund for at least 10 years and the new capital gains taxes generated from the opportunity fund investment are slashed to zero.
The 1031 exchange is a valuable tool in the real estate investors toolbox and with proper planning and understanding the investor can utilize the features of this piece of the tax code which has been around since 1921. To learn more about 1031 exchanges and your 1031 exchange options utilizing DST, NNN and Opportunity Zones please visit www.kpi1031.com. You will also, upon registering, be sent a free book on 1031 exchanges.
*Diversification does not guarantee profits or protect against losses.