Building Wealth Through Real Estate: The Impact of 1031 Exchange

Considering a 1031 exchange when contemplating selling your investment property can be a smart move. This transaction type allows real estate investors to defer capital gains taxes upon sale by reinvesting in a like-kind property. Named after Section 1031 of the Internal Revenue Code, it’s a well-established tax benefit often utilized by investors for its tax advantages. By reinvesting the sale proceeds within the specified time period in a property of similar kind and equal or greater value, investors can effectively “trade up” while deferring paying capital gains tax. A win-win!

For example, with a 1031 exchange, an investor can sell a warehouse and use the proceeds from the sale to acquire a multifamily asset in a new geographic region. In this example, the investor wouldn’t have to pay capital gains tax to the IRS if they identified a property in writing to an intermediary within 45 days of the sale of the property and closed on it within 180 days.

The government’s goal in creating this rule is to make it easier for investors to keep investing in real estate, growing communities, keeping the economy strong, and providing taxpayers with the opportunity to accumulate wealth over time.

While the benefits are enticing, there are also associated risks. Let’s delve into both aspects to help you decide whether a 1031 exchange is right for you.

Benefits of a 1031 Exchange

  1. Deferring Capital Gains Tax: The primary advantage of a 1031 Exchange is deferring capital gains tax, freeing up capital for investment in the replacement property. This allows for potential cash flow improvements or investment in properties with greater earning potential while allowing investors to grow wealth faster. For example, if you originally invested $50,000 in a property and sold it for $100,000 five years later, you doubled your investment. Instead of paying capital gains tax, a 1031 exchange allows investors to defer the tax payment and instead invest $100,000+ in another like-kind property. This transaction can be repeated, allowing the investor’s wealth to grow.
  1. Exposure to New Markets: A 1031 exchange allows investors to invest the sale proceeds in a real estate asset in a new geographic area. This is extremely beneficial as markets grow at different times. For example, the Sunbelt experienced rapid growth during the pandemic as people were looking for jobs in growing areas that offered more space and a better quality of life. Investors opting to leverage a 1031 exchange for their next investment, can further diversify their portfolio by investing in new MSAs.
  1. Maintain Capital Liquidity: Executing a 1031 exchange allows investors to maintain capital liquidity with minimal downtime. Avoiding the disruption caused by liquidating an investment and searching for a replacement opportunity can provide continuous income generation.

Potential Risks

  1. Complexity: The 1031 exchange structure is an intricate transaction requiring meticulous attention to regulations. Additionally, if there are multiple people involved in the real estate investment and only some want to participate in the 1031 exchange, it can be problematic. If there are three investors who each own a third of the investment and only two want to participate in the transaction, for example, those two people would need to buy out the third investor, making him/her whole before moving forward with the 1031 exchange.
  1. Reinvestment Requirement: To defer all capital gains tax, the entire net proceeds from the sale must be reinvested into the replacement property, along with acquiring debt equal to or greater than the previous property. In the example we shared earlier where the investor acquired the property for $50,000 and sold it for $100,000, the entire $100,000 would need to be invested in the new property, not just the $50,000 gain.
  1. Liquidity: With a 1031 exchange, investors will not be able to access the profit from the sold property. Before considering a 1031 exchange, investors should speak with their tax advisor to ensure that it is the right move for their financial situation.

Timing is Everything

When contemplating the sale of a property, we encourage investors to gauge their interest in participating in a 1031 exchange. Early involvement is crucial, as identifying a replacement property within 45 days of closing and completing the purchase within 180 days are requisite for compliance.

Investors should also engage a qualified intermediary to manage funds between the sale of the initial asset and the acquisition of the replacement property as well as seek advice from a tax professional to understand the full implications of the transaction.

Is a 1031 Exchange Right for You?

Despite its complexities, a 1031 exchange offers compelling benefits for investors seeking tax advantages and wealth preservation. Real estate investors have been leveraging 1031 exchanges for decades to growth their wealth and “trade up” to bigger, more lucrative real estate investments.

Want to Explore a 1031 Exchange?

If you are interested in exploring the benefits of a 1031 exchange or hearing more about investment opportunities with Lucern Capital Partners, please reach out to David Hansel, managing partner.