1031 Exchanges: An Investor’s Trump Card

Capital gains are amazing, and arguably the main reason behind investing in anything. Capital gains taxes, however, can greatly diminish an investor’s profits. Luckily, multifamily investors can utilize a 1031 exchange to avoid dealing with capital gains taxes. 

Highlights of the blog:

• Understanding 1031 Exchanges
• Considerations Before Executing a 1031 Exchange
• How to Avoid Disallowing a 1031 Exchange
• Benefits of Leverage in 1031 Exchanges

Understanding 1031 Exchanges

Understanding the ins and outs of the 1031 exchange is a huge benefit to apartment investors. In the most simplified of explanations, a 1031 exchange allows a property owner to offload an asset and use the equity to purchase a new property, with 100% of capital gains taxes deferred. Essentially, investors can defer capital gains taxes and invest the resulting capital returns in real estate without paying anything to the government besides the actual tax obligation owed if they do not exercise their right to a 1031 exchange in the future.

The key benefit of the 1031 exchange and what makes it different from the standard sale of an asset is found in the fact that the transaction is an exchange and NOT a sale. The exchange of one property for another allows for the taxpayer to avoid the tax of the “sale”, and qualify for deferred capital gain treatment. 

1031 Exchanges and the Depreciation/Appreciation of Multifamily Properties

The 1031 exchange is perfect for investors with multifamily properties that have either appreciated or depreciated significantly.

In the event your multifamily building has depreciated to the point of being ineligible for annual depreciation deductions on tax returns, then your multifamily property’s annual returns have also depreciated, indicating the need to change properties to maximize investment returns.

For appreciation, if the apartment property has reached, or is close to reaching its maximum appreciation potential, it may be better to exchange for a new property with more upside. This strategy is particularly useful in a low-interest rate environment, wherein the investor can exchange the asset for more property, with increased income and potential long-term appreciation.

Considerations Before Executing a 1031 Exchange

Replacement Property Criteria

The 1031 exchange applies only to real estate. It does not cover “exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets” (“Like-Kind Exchanges”). This means that the chosen replacement asset must be of a similar type and class to be eligible for the exchange.

Determining What Like-Kind Looks Like in a 1031 Exchange:

To determine what like-kind properties are, in this case, we are talking about exchanging one multifamily property for another. Furthermore, 1031 exchanges are for multifamily properties. Personal properties are not covered by the 1031 exchange.

Vacant property is always considered like-kind, whether leased or not leased.

Property Titles

The property titles must be identical in a 1031 exchange. The taxpayer whose name is listed on the relinquished property must be the same taxpayer that is listed on the purchased property. The same trust or corporation that is listed on the title of the relinquished property must be listed on the title of the purchased property.

The Reverse Exchange

In the event of delayed payment from the sale of the relinquished property, the reverse exchange proposes a solution for investors. To avoid having both properties of the exchange titled in the same name at the same time, the purchased property will go into an exchange accommodation titleholder or EAT, typically an LLC, and the profit and title will be held by the LLC until the first property is relinquished.

The Right Time to 1031

A key factor behind the benefits of a 1031 exchange is timing. The 1031 exchange starts on the date the deed is recorded or the date the relinquished property is transferred to the buyer. The 1031 exchange ends 180 days after the exchange begins.

The replacement property must be identified within 45 days of the relinquished property’s closing. The replacement property must be purchased within 180 days of the relinquished property’s closing.

How Deferred Capital Gain Works

In exchange, capital gains taxes are deferred. The exchange is not 100% tax-free; the taxes are deferred until the sale of the property. If the property owner dies before an actual sale of the property, their children can acquire the property with little to no taxes.

How to Avoid Disallowing a 1031 Exchange

An Intermediary Party is Required

Many people like to do everything themselves. In the case of a 1031 exchange, this is not possible. A third party is necessary for the exchange to be valid, and taxes to be deferred.

Utilize a Reverse Exchange When Necessary

Holding both the property that is up for sale and the replacement property at the same time will disallow the exchange. The reverse exchange protects against this.

Be Mindful of Boot

Investors that use debt within exchanges may pay off the debt with the sale of the relinquished property and think they’re debt free. However, this debt used in the relinquished property is known as boot: the amount of debt owed from a sale that has to be accounted for. Having boot will incur capital gain taxes.

Benefits of Leverage in 1031 Exchanges

Investors can use leverage to acquire more property for their replacement properties rather than using cash to finance the entire exchange.

For example, if the relinquished property sells for $1M in cash, the $1M can be used as a down payment and a loan can be used to finance multiple or more expensive multifamily properties. 

By leveraging $2MM, a buyer can buy a $2MM multifamily property, a $4MM property (with a 50% loan), or a $10MM property (with an 80% loan). 

If the original property was leveraged, the new property must suppose to have an equal or greater amount of debt. As long as the capital gains debt from the original property is replaced, the investor can take out more leverage to purchase more property.

Furthermore, investors looking to finance the additional costs of their replacement property may find partners willing to furnish some or all of the money. There are also some sellers who might be willing to finance their own property’s price to assist with closing costs or simply to provide some extra leverage.

Conclusion

It is safe to say that it is a great investment opportunity to leverage the rights afforded by the 1031 exchange, specifically when investing in multifamily property. The government is giving investors the right to invest their own money at no additional cost to the investor. Furthermore, with treasury yields as low as they are, there’s an added benefit to using leverage to purchase more property at a very reasonable cost. Now is a great time to use a 1031 exchange to invest in a new property, or portfolio of properties using a bit of leverage to bolster both short and long-term returns.