Benefits of 1031 Exchanges Go Beyond Tax Savings
Any investor who has ever done a 1031 exchange will be quick to tell you that the number one benefit is the tax savings. Individuals and corporations alike can avoid what oftentimes adds up to a hefty capital gains tax bill on the sale of a property. Yet investors who look beyond the tax savings also find a number of benefits that can further tip the scales in favor of doing a 1031 exchange.
Certainly, the tax savings alone are a powerful incentive. In fact, investors are just as likely to hear about the benefits of a 1031 exchange from their accountant or financial advisor as they are a commercial real estate broker. The structure was originally created under Section 1031 of the U.S. Internal Revenue Code, and it has been widely used by commercial real estate investors since the late 1970s.
Portfolio diversification & upside potential: Investors often use 1031 exchanges to grow and diversify real estate portfolios by investing into different property types and/or buying properties in different geographic regions. An investor might use the proceeds from the sale of a long-owned apartment property that has passed its prime in Los Angeles to buy a portfolio of assets, including industrial buildings, net lease properties, and apartments in fast-growing cities such as Austin, Raleigh, or Omaha, and extract potential higher income returns and longer-term upside.
Wealth building strategy: Investors have long used 1031 exchanges as a wealth building strategy. Profits from a sale that would have gone towards paying the IRS can instead be reinvested and continue to earn a return. For example, a married couple sold an office building in Santa Monica. The sale resulted in a capital gain of $8 million that would have been taxed at a rate of 20% based on their tax bracket. Instead of paying that $1,600,000 to the government, the owners chose to do a 1031 exchange, deferring the tax indefinitely and investing proceeds in the acquisition of a portfolio of diversified and marquee triple net lease properties including Walgreens, 7-Eleven, Starbucks, and Dollar General throughout the U.S.
Stepped-up basis: 1031 exchanges also hold added estate planning benefit. When a property that was acquired through a 1031 exchange passes to heirs upon the death of the owner, the asset receives a stepped-up basis, meaning the recipient receives the property at market value. Any previous capital gains that had been deferred over the years do in fact disappear in this case with a new reset in value for the new owner. Imagine a hypothetical scenario in which you bought a multifamily apartment 20 years ago for $430,000 that is now worth $1.8 million. Twenty-five years from now upon your passing, your heirs will inherit this property valued at $9.6 million, with the step up in value that is essentially tax-free. This is a key facet of generational wealth building and estate planning.
In addition to the benefits of a 1031 exchange, investors need to be mindful of potential downside risks. Chief among those are following the IRS guidelines to make sure the transaction checks all of the boxes for a qualified exchange. Notably, the seller must identify the replacement property within 45 days of the date they sell the original property and close on the purchase of the replacement property within 180 days. Finding a viable replacement property and certainty of execution are paramount to completing a 1031 exchange within the allowed timeframe.
Therefore it is important for investors to not get blinded by the potential tax savings, and make sure that replacement property is a good, solid investment that meets an individual’s investment objectives related to risk tolerance, appreciation, income, and overall return. As such, it is especially important to work with a certified 1031 Exchange Qualified Intermediary who understands the nuances of 1031 exchanges and partner with an experienced broker that can help you maximize your investment opportunity so that you can enjoy your freedom. Please contact Andrew Vu at 415-539-1120 for a complimentary strategy consultation.