In our last post on 1031 exchanges, we explained what they are and how they deliver a unique tax deferral benefit for real estate investors or selling business owners with real estate.
But like any financial tool or strategy, there are plusses and minuses with 1031 exchanges. This post will examine these aspects, providing clarity for those considering this strategy.
Why Consider a 1031
A 1031 exchange strategy is flexible in that there are several reasons investors might put one to use. Here are some of the most common:
- Sell in an “up” market
- Portfolio diversification (e.g., new geography, different asset type)
- Tenant or management issues
- Diversify into multiple investments
- Other attractive investments are available
- Defer substantial capital gains tax liabilities
- Structure a tax-efficient, long-term legacy vehicle for heirs/estate
As you can see, motivations behind a 1031 exchange vary greatly. That’s why one of the best features of the 1031 strategy is its flexibility. It can help accomplish many different goals.
However, the 1031 exchange strategy is not perfect. Here are some downfalls of a 1031 exchange:
- Little or no access to profits
- Can’t use money from sale for personal use (e.g., new car, pay down debt, etc.)
- Proceeds must be reinvested in “like kind” real estate (i.e., income-producing property)
And of course, there are strict rules from the IRS that you must follow. For example, the exchange must be executed properly to avoid substantial tax penalties. Also, a qualified intermediary must be in place to “custody” the sale proceeds between the sale and exchange into the new investment.
When you attempt to exchange another “direct” property you will majority own, things can get even more complicated:
The Three-Property Rule – You can identify up to three (not more!) potential exchange properties and acquire any or all of them. This limits the scope of opportunities for your next investment.
The 200 Percent Rule – Any identified exchange properties must not exceed 200 percent of the sold property’s total value. If you are looking to move up to larger projects, this is a limiting factor.
Identification Time Limit Rule - In addition, you have 45 days from your property sale to identify the next investment(s). This may limit you to only what’s available “on the market.”
Also, you have 180 days from your property sale date to close on the new investment. That sounds like plenty of time. But it can be quite short if you run into legal, environmental, title, or seller issues. In such cases, you may need to go back to another identified property (two left out of three identified initially).
Despite the rules and challenges associated with 1031 exchanges, they remain incredibly powerful tax management tools and can satisfy many investment goals.
While 1031 exchanges may seem like a specific strategy, there are some unique alternatives out there designed to achieve similar goals. Our next post will focus on those and how they can deliver results for real estate investors.
Securities sold through CoreCap Investments, Inc., a registered broker-dealer and member FINRA/SIPC; advisory services offered by CoreCap Advisors, Inc., a registered investment advisor. Cornerstone Financial and CoreCap are separate and unaffiliated entities.