Tax Basics Part 3 – 1031 Exchanges

One powerful strategy that can significantly enhance the returns for investors in real estate syndications is the 1031 exchange. In this last blog post of the Tax Basics series, we’ll explore the benefits of a 1031 exchange and how it can be a game-changer for investors participating in real estate syndications. While this topic can be considered one that is more advanced, it’s been included in this series because of how useful it can be. For context, it’s important to  know the capital gains tax rate on commercial real estate:

•  Short-term Capital Gains: When a commercial property is held for less than 1 year, the capital gains tax is generally the same as ordinary income. So, an investor would pay between 10% and 37% as federal capital gains taxes for properties held for a year or less. The level of taxable income of the investor determines the tax percentage.
• Long-term Capital Gains Tax: When a commercial property is held for over 1 year,  the applicable tax rates start at 0% (long-term capital gains taxes are not applicable up to a specific limit) and go up to a maximum of 20%.

Note – The definitions of the technical terms in any of our posts can be found in the glossary section of our website.

Overview

A 1031 exchange, also known as a like-kind exchange, derives its name from section 1031 of the Internal Revenue Code (IRC). This rule is a tax-deferred strategy that allows real estate investors to sell a property and reinvest the proceeds into a new property of equal or greater value without paying immediate capital gains taxes. For example, let’s say that you sell a 12-unit multifamily property that you own and use the proceeds from the sale to go and buy a similar apartment building. By taking advantage of the 1031 Exchange rule, you would not have to pay any taxes that resulted from the sale.

The goal of this rule was to incentivize real estate investors to continuously invest in real estate. Real estate investors provide a benefit to society by helping people have a place to live. Because of that service, the government wanted to help out real estate investors in the form of tax deferral. So long as investors continue to purchase properties, and increase the value of their investments through various means, the government benefits because the housing market becomes stronger and tenants get a larger selection of places to live.

The Pros

1. Deferring Capital Gains Tax: The biggest and most obvious advantage of the 1031 Exchange is that investors can defer capital gains taxes which allows for their wealth to grow faster. For example, let’s say that you invested $100K into a property and after several years the property is worth $200K. For this example, let’s say that the capital gains tax at sale would be $40K. The 1031 Exchange allows you to defer that tax (i.e., not pay it) and take the full return of your investment. You can keep exchanging for as long as you want, but once you decide to sell or use those funds for a building that is not similar, you will have to pay the taxes. The good news is that if your investment grew, it’s likely that you would be able to pay the taxes and make a profit.

2. Leverage for Larger Investments: Investors have the option to leverage the proceeds from a property sale through a 1031 exchange to acquire larger and potentially more lucrative properties. Thus, if it’s possible for someone to continuously exchange into larger and larger assets and grow their portfolio. Many investors take advantage of the ability to scale up and earn increasing amounts of cash flow.

3. Defer Taxes Until You Die: If you choose to do so, you can literally just keep swapping properties with the 1031 property exchange until you die, deferring capital gains taxes the entire time. There is a saying that is used by real estate investors: “Swap until you drop.” What makes it even better is that you can leave the properties to your heirs and they won’t have to pay the accumulated capital gains taxes on the properties that were used in the 1031 exchange. Instead, they will inherit the properties in a “step-up” basis which means that they will inherit the properties at the current fair market price of the asset. All of the capital gains that have accumulated up to that point will simply vanish. This strategy is one that people choose to use in order to build generational wealth.

The Cons

1. Rolling Over the Profit and Initial Investment: If an investor decides to move forward with a 1031 exchange, they will not be able to access the capital gains made from the sale of the property. They will have to roll them into the next investment. For example, let’s say that you make $50K in profit from the sale of a 10-unit apartment building. If you want to take the money and invest it in a stock, you would have to pay taxes on the profit. In order to keep the protection of the 1031 exchange, an investor can only put the money toward a “like-kind” investment, meaning it has to be another apartment building similar in scope. What’s also important to note is that the investor has to roll  over the initial investment in addition to the profit. Sticking to the example above, if the investor paid $100K for the property, they would need to roll over the $100K and the $50K profit. Some people make the mistake of only rolling over the capital gains and then land themselves in trouble for spending the underlying investment. 

2. Difficult to Understand: The 1031 exchange structure can be hard for some people to deal with, especially if there are multiple people involved in the real estate investment. For example, let’s say that you invest in a multifamily syndication and only some of the investors want to do a 1031 exchange, this can be a problem. If five investors own 20% each in the asset, and two want to take their money out, then either one of two things need to happen:

• Option A: The three investors buy the liquidating partners out and then roll over 100% of the partnership’s initial investment and profits
• Option B: The investors need to separate the partnership in the title-holding company into two different companies: one that is rolling the funds over and one that is liquidating. 

While either option is possible and will effectively deal with the situation, it can be a little more complicated than some people would like. 

Conclusion

The 1031 Exchange has been around for over 100 years and it’s been like that for a great reason, to defer taxes and encourage investments in real estate. From tax deferral and compounding returns to scaling up and enhanced flexibility, the advantages of a 1031 exchange can be a great tool for investors. It’s important to work closely with a CPA or Tax Strategist to maximize the benefits.

If you have any questions regarding the terms and concepts in this post or previous ones, please reach out to either me (tedi.nati@jpacq.com) or someone on our team so we can help explain further. If you’re interested in investing with us at JP Acquisitions, you can contact us via our contact form, by emailing a member of our team, messaging us on LinkedIn, or signing up for our investor portal to set up a meeting.

As always, I hope you enjoyed reading this post as much as I have writing it. Best of luck!