First Things First- Is a §1031 Exchange Right for Your Investment?

There’s often a deci­sion that investors need to make when it comes time to sell­ing a prop­er­ty that has appre­ci­at­ed in val­ue. That ques­tion is do we sim­ply pay the cap­i­tal gains tax­es on our prof­it and go on our mer­ry way.

August 8, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

Alter­na­tive­ly, do we look at tax strate­gies that include §1031 exchanges to defer cap­i­tal gains. There is also the recap­ture of depre­ci­a­tion that may be an addi­tion­al con­sid­er­a­tion.  Add in any state income tax and the deci­sion may get hard­er to make.  That always seems like a big issue when we inter­face with investors who are very hap­py that their prop­er­ties have gone up in val­ue but are some­what tak­en back when they must pay cap­i­tal gains on that prof­it. There is also the detail of replac­ing any debt paid off with new debt of cash. Depend­ing on the state you live in, prof­its tak­en on a prop­er­ty may result in as much as 25 to 30% or more in cap­i­tal gains tax­es. Although we have tools on our web­site to pro­vide an idea of poten­tial cap­i­tal gains it is best to con­sult your tax advi­sor. So, if you were look­ing to defer cap­i­tal gains on the sale of a prop­er­ty that it’s appre­ci­at­ed in val­ue you need to fol­low obvi­ous­ly all the rules of the §1031 exchange.

The real ques­tion is can you estab­lish, or do you under­stand what your cap­i­tal gains tax impli­ca­tions are based on your hold­ing peri­od. Typ­i­cal­ly, investors will deal with their CPA’s or accoun­tants to deter­mine the under­ly­ing basis that is in the prop­er­ty. The basis is sim­ply what you’ve paid for the prop­er­ty and any improve­ments that you may have made to the prop­er­ty while you’ve held the prop­er­ty, and that amount is reduced or low­ered by the depre­ci­a­tion on the prop­er­ty over the hold­ing. The hold­ing peri­od depre­ci­a­tion sched­ules will be dif­fer­ent depend­ing on the type of prop­er­ty, mean­ing res­i­den­tial prop­er­ty (which is depre­ci­at­ed over 27 1/2 years) and com­mer­cial prop­er­ty (which is depre­ci­at­ed over 39 years). Investors that are faced with mak­ing a finan­cial deci­sion in a quick peri­od of time may be scram­bling to estab­lish what all their num­bers are regard­ing their own­er­ship of the invest­ment prop­er­ty. What may com­pli­cate the under­stand­ing of these num­bers may be part­ner­ships with oth­er investors. Occa­sion­al­ly investors own dis­pro­por­tion­ate inter­est in the prop­er­ty which will then deter­mine their pro­por­tion of prof­it to be extract­ed from the prop­er­ty if and when it is sold.

When we receive a phone call from a poten­tial investor who is look­ing at sell­ing their prop­er­ty uti­liz­ing a §1031 exchange and replac­ing their invest­ment prop­er­ty with a Delaware Statu­to­ry Trust or DST. We often start by sim­ply ask­ing a few ques­tions. What did you pay for the prop­er­ty, how long have you had the prop­er­ty, where do you stand with your cap­i­tal gains amount and what’s your pro­ject­ed cap­i­tal gains tax that you’re going to pay. We also want to take a look at any off­set­ting cap­i­tal loss­es that the investor may have that may off­set cap­i­tal gains.

Investors who move into a §1031 typ­i­cal­ly under­stand that this is a long-term strat­e­gy for build­ing poten­tial wealth that may be con­sid­ered gen­er­a­tional in nature. If the investor sells the prop­er­ty, the cap­i­tal gains would be due upon the sale of the prop­er­ty if anoth­er §1031 is not uti­lized.  There is a cliché of “swap ‘till you drop”.

So, let’s take an over­all look that when a §1031 exchange may be the right invest­ment strat­e­gy for you

1. Defer­ral of cap­i­tal gains tax: if your aim is to defer pay­ing cap­i­tal gains tax on the sale of the prop­er­ty this would be one of the pos­i­tive rea­sons to enter into the §1031 exchange.
2. Invest­ment Growth: there is a ratio­nale among investors, espe­cial­ly those who invest in real estate to pur­chase a prop­er­ty, sell it and rein­vest the pro­ceeds in the next piece of real estate. At some point in time the investor may become tired or frankly worn out from man­ag­ing a cer­tain style of prop­er­ty and want to sell the prop­er­ty and move to anoth­er prop­er­ty, either asset class or geo­graph­ic loca­tion. The bet­ter loca­tion or dif­fer­ent style asset class may increase cash flow or have a bet­ter poten­tial of increas­ing in val­ue over the hold­ing peri­od.
3. Invest­ments held for long term: most real estate investors real­ize that hold­ing peri­ods for real estate prop­er­ties exceed many oth­er invest­ments espe­cial­ly invest­ments in stocks or mutu­al funds. So, the real estate investor needs to look at their invest­ments as a long-term hold­ing posi­tion. Investors that are buy­ing prop­er­ties improv­ing them to flip the prop­er­ties do not qual­i­fy for a §1031 exchange. The only excep­tion may be if the prop­er­ties are held for more than one year from the acqui­si­tion date.
4. Con­sol­i­dat­ing Prop­er­ties: Investors that own small­er prop­er­ties or mul­ti­ple prop­er­ties may want to sell the small­er prop­er­ties and invest in a larg­er prop­er­ty. This would be con­sid­ered a con­sol­i­da­tion approach to own­ing real estate. The same may be true for a real estate investor sell­ing a large prop­er­ty and mov­ing into sev­er­al small­er prop­er­ties. This may be con­sid­ered diver­si­fi­ca­tion.
5. Estate Plan­ning: One of the biggest ben­e­fits of a §1031 exchange port­fo­lio would be a method for estate plan­ning. Investors look­ing at build­ing gen­er­a­tional wealth under­stand the ben­e­fits of a step up in basis to cur­rent val­ue when the investor pass­es away. So, the heirs will ben­e­fit from this step up in bases mean­ing that there would be no cap­i­tal gains or recap­ture of depre­ci­a­tion that will need to be paid.

When It Might Not Be Right:

1. The need for cash: the need for imme­di­ate cash is one of the rea­sons why an investor may not go into a §1031 exchange. All of the pro­ceeds from the exchange need to be put into the replace­ment prop­er­ty to achieve full defer­ral of cap­i­tal gains and the tax­es asso­ci­at­ed with the cap­i­tal gains. If an investor needs cash from the sale of a prop­er­ty that cash is con­sid­ered boot. There would be the cap­i­tal gains tax due on that amount of cash retained.
2. Your pri­ma­ry res­i­dence is exclud­ed: your pri­ma­ry res­i­dence may be your most valu­able real estate hold­ings, but it is not con­sid­ered a qual­i­fy­ing prop­er­ty for a §1031 exchange.
3. The dev­il is in the detail.: There are com­plex rules with regards to tim­ing of the replace­ment prop­er­ty clos­ing. There is also a crit­i­cal date for iden­ti­fy­ing poten­tial prop­er­ties that may qual­i­fy as replace­ment prop­er­ties. The 45-day rule to iden­ti­fy in the 180 days to com­plete the clos­ing of the replace­ment prop­er­ties may be a big stum­bling block for cer­tain investors.
4. Tired of own­ing real estate: at some point in time real estate investors may grow weary of own­ing real estate and may seek to diver­si­fy out­side of the real estate asset class into more tra­di­tion­al invest­ments.
5. Is there enough gain: if you are sell­ing a prop­er­ty which has lit­tle or no game there may not be enough tax advan­tages to go through the 1031 exchange.
6. Poten­tial Oppor­tu­ni­ty Zone: there are oth­er arti­cles we have writ­ten that describes to ben­e­fits of mov­ing into an oppor­tu­ni­ty zone.  Short ver­sion- only the cap­i­tal gains need to be rein­vest­ed and investor may retain the basis.  There are oth­er pro­vi­sions as well that need to be fol­lowed such as the ten-year hold­ing peri­od to max­i­mize ben­e­fits.  Cap­i­tal gains tax­es are deferred by need to be paid by April 2027.

Action steps:

• Investor long term plans: investors should con­sid­er their long-term invest­ment plans and dis­cuss with the tax advi­sors how best to reach those goals which may include real estate own­er­ship. Not all CPA’s deal in §1031 exchanges every day. Seek­ing com­pe­tent advice is the key for any pru­dent invest­ment.

Investor Restric­tion:

DST’s (Delaware Statu­to­ry Trusts) are for accred­it­ed investors only.  Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and com­pli­ment your finan­cial objec­tives. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, in any form, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed. 

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