If you’re thinking about selling one investment property and buying another at the same time, you may also want to consider a 1031 tax-deferred exchange.
This practice takes its name from Section 1031 of the U.S. tax code and allows property owners to sell real estate and purchase a comparable property while deferring capital gains tax.
1031 lets property owners avoid paying capital gains when selling an investment property, and then reinvest the proceeds of the sale.
At Equity Retail Brokers, we work with Margo McDonnell, whose 1031 Corp specializes in these exchanges. We spoke to Margo, 1031 Corp’s president and CEO, about some of the facts – and a few of the myths – surrounding this popular and profitable program.
Equity Retail Brokers: What is the most powerful benefit of a 1031 exchange?
Margo McDonnell: A 1031 exchange allows investors to grow their real estate portfolio with pre-tax dollars. Rather than paying the tax now and losing all opportunity for future earnings, a 1031 exchange enables you to reinvest all equity in replacement property so that money will continue to appreciate tax-deferred.
You can exchange repeatedly and no tax is due provided you continue to acquire replacement property of equal or greater value and you reinvest all equity. The gain is deferred indefinitely. A trade down in value or equity or failure to exchange and doing an outright sale will trigger a taxable event.
When someone dies, their heirs will inherit the property with a stepped up basis and all deferred gain is forgiven. The first $11.4 Million of an estate is exempt from federal estate taxes, so you have the potential of not just growing your real estate portfolio with pretax dollars but passing the wealth to the next generation with no estate taxes. In 2020, the estate tax exclusion will rise to $11.58 Million.
Beyond that, other benefits of a 1031 exchange include:
- The chance to acquire replacement property with increased cash flow or less management responsibility
- An exit strategy for business owners have real estate but want to acquire an income-producing replacement property
- A chance for businesses to expand or relocate
- The ability to refinance a replacement property to pull cash out tax-free
ERB: What are some of the common misconceptions about 1031 exchanges that might trip people up when they employ them for the first time?
MM: There are two very common misconceptions:
First, that you have to acquire the same type of replacement property. The fact is that you can acquire any time of real property provided it is used for business use or held for investment.
While referred to as a like-kind exchange, the term like-kind refers to the nature or character of the property not the specific type of property. You can sell and/or buy multiple properties and they can be located anywhere in the U.S.
There is great flexibility in what you can purchase. For example, you can sell an office building and acquire a multifamily development or sell a portfolio of office condos to acquire a NNN property.
The second misconception is that You have to reinvest all of your proceeds to make the 1031 exchange work. It is true that to maximize your tax-deferral, you must acquire a replacement property that has equal or greater value and equity than in the old property but it is possible to trade down in value or equity and pay tax on the value of the trade down.
It is always a good idea to discuss the tax consequences of a proposed 1031 exchange with your tax advisor but it’s especially important when trading down. While a 1031 exchange is a great tax strategy, it is not always the right one in every situation.
ERB: Have there been any changes in the 1031 landscape and do see any changes in the laws or landscape moving forward?
MM: The 2018 Tax Cuts and Jobs Act did significantly change Section 1031. Personal property exchanges were repealed but real property exchanges were preserved. You can no longer exchange tangible and intangible personal property, such as F, F & E, franchise agreements, liquor licenses, etc., although some personal property or capital assets will qualify for 100% immediate expensing.
The 1031 industry was very worried about the future of like-kind exchanges and did quite a bit of work educating members of Congress and their staff on the importance of 1031 exchanges on the real estate market and the economy as a whole. Macro and micro economic impact studies looked at the positive impact provided by this 98-year old tax strategy.
We showed that its intended purpose of encouraging reinvestment upon a sale and not taxing a seller who reinvested all proceeds and did not receive any cash are just as valid today as they were in 1921 when like-kind exchanges were created. While a repeal of real property exchanges could always be included in a future tax bill, the 1031 industry is hopeful our continued efforts to educate members of Congress on how exchanges work and their importance will keep 1031 in the tax code.
ERB: What is the role of the Broker in maximizing value for a client in 1031 Exchanges?
MM: The broker has the important job of helping the Exchanger find a buyer for their relinquished property and more importantly, helping them find the replacement property that best fits their investment and/or business needs.
More importantly, it is often the broker who introduces the idea of the 1031 exchange to their clients. While exchanges have been allowed since 1921, there are still many investors and business owners who are unfamiliar with them and if they are familiar, they don’t realize how easy an exchange actually is.
While sellers are encouraged to discuss the tax consequences of the proposed sale with their tax advisors, many do not until after the sale has occurred and then it too late to initiate the 1031 exchange. Equity Retail Brokers will suggest a seller consider an exchange when they are first talking about listing the property for sale. This gives their clients time to discuss the tax consequences with their tax advisor and start looking for replacement property much sooner, allowing their clients to maximize their time.
ERB: What do you like about working with brokers at Equity Retail Brokers?
MM: I appreciate the opportunity to work with Equity Retail Brokers because their brokers are focused on doing what is right for their clients and not just driven by commissions.
They take the time to learn what their clients want to get out of the transaction and what are their short and long-term objectives. They work hard to do right by their clients and find the best possible replacement property.
They are conscientious about helping their clients find replacement property within their 45-Day Identification Period and often times even before their relinquished property has been transferred to a buyer. The brokers at Equity Retail Brokers are professional and responsive, which makes the transaction more pleasant for all parties.
A smooth 1031 exchange requires detailed market knowledge and strict adherence to the tax code. Let Equity Retail Brokers remove guesswork from this equation, as we provide a detailed, customized approach for each client to ensure a successful transaction. Contact us today to learn more.