1031 Exchange Explained

Definition

Named after Section 1031 of the U.S. Internal Revenue Code.

The main purpose of a 1031 exchange is to incentivize investors to use the proceeds from the sale of an asset to buy more real estate instead of cashing out.

Sell your property → find and buy another “like-kind” property → defer capital gains taxes

The properties must be "like-kind" meaning the exchanged properties must be used for investment or business purposes.

For example, a commercial building can be exchanged for raw land, industrial, medical, vacation rental, Air BnB property, net lease, etc. as long as the asset is used for investment purposes. If you have specific questions about selling your property or 1031 exchanging, please fill out the form at the bottom of this site to connect with one of our trusted 1031 exchange partners.

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Let's consider an example comparing the financial outcomes for an investor selling a property without using a 1031 exchange versus electing to use one, with the following assumptions:

  • Property Sale Price: $500,000
  • Original Purchase Price (Basis): $300,000
  • Depreciation Claimed: $50,000
  • Capital Gains Tax Rate: 20%
  • Depreciation Recapture Tax Rate: 25%

Without 1031 Exchange

  1. Capital Gains:
    • Sale Price: $500,000
    • Adjusted Basis (Original Purchase Price - Depreciation): $300,000 - $50,000 = $250,000
    • Capital Gain: $500,000 - $250,000 = $250,000
  2. Taxes Owed:
    • Capital Gains Tax: $250,000 * 20% = $50,000
    • Depreciation Recapture: $50,000 * 25% = $12,500
    • Total Tax: $50,000 + $12,500 = $62,500
  • This leaves you with only $437,500 leftover to buy another property

With 1031 Exchange

  1. Capital Gains Tax Owed: $0 (deferred)
  2. Depreciation Recapture Tax Owed: $0 (deferred)
  3. Total Tax: $0 initially, until the replacement property is sold without another 1031 exchange - most investors continue to 1031 exchange indefinitely and pass on their assets to their children at a “stepped-up” basis.

Financial Impact Comparison

  • Without 1031 Exchange: The investor has $437,500 left after taxes ($500,000 - $62,500) to reinvest.
  • With 1031 Exchange: The investor has the full $500,000 to reinvest in another property, deferring all taxes.

The 1031 exchange allows the investor to leverage the full sale proceeds for reinvestment, deferring taxes and potentially increasing the return on investment by using pre-tax dollars to purchase a new property.

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Through a 1031 exchange, an investor can boost cash flow by:

Trading Up: Use full sale proceeds to invest in properties with higher rental yields.

Diversifying: Enter new markets or property types with superior cash flow prospects.

Leveraging: Employ borrowed funds to obtain more valuable properties, increasing rental income.

Popular 1031 Exchange Investment Opportunities:

Diverse Real Estate Types: Shifting into various real estate sectors like commercial, residential, or industrial for diversification or consolidation and growth.

Example 1: Selling apartment portfolio (management intensive) and consolidating into one larger asset with less or no management responsibilities such as a NNN property.

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Example 2: Selling one large asset such as a distribution facility and diversifying into several smaller assets.

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Delaware Statutory Trusts (DSTs): Offering fractional ownership in premium real estate, providing potential for stable returns with minimal direct management. This helps the average investor get exposure to institutional quiality assets, but more difficult to sell if you ever want your capital back.

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NNN Properties: Preferred for their predictable income and low management effort, where tenants handle most or all property expenses and maintenance.

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In NNN leases, the tenants handle all management and expenses related to the property.

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What’s the catch of a 1031 exchange?

Timing constraints: 45 days to identify a replacement property, 180 days to complete purchase.

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  • Like-kind requirement for properties.
  • Investment in equal or greater value property for full tax deferral. If less than full sale amount, you pay capital gains taxes on the difference known as the “boot”.
  • Mandatory use of a Qualified Intermediary (QI).
  • Cost of a Qualified Intermediary generally ranges from $600 to $2,000, varying with transaction complexity.