1031 Exchanges – Enhancing Return by Deferring or Eliminating Taxes
A fair number of clients invest in income producing real estate – either with our help or on their own. The income generated from these investments can be attractive. Depreciation deductions can make the after-tax returns of that income even more appealing (for those with investment real estate that are unfamiliar with cost segregation studies, which can further enhance the benefits of depreciation, please let us know).
Unfortunately, when it comes time to sell, there is often a very different tax story. Due to a concept known as “depreciation recapture,” all the prior depreciation on the property is deemed to be income at the time of the sale (beware: the IRS does not care if you actually depreciated the property; if you should have used depreciation but did not for some reason, you are still subject to recapture of the depreciation you should have recorded). On top of that, there are taxes on any gain in the value of the property.
By way of a simple example, assume the following facts regarding an investment property:
Given the above, most people mistakenly believe that only owe taxes on the difference between the purchase price and the sale price, a $1 million gain in this example. Unfortunately, when it comes time to pay taxes, you would pay taxes on $500,000 of depreciation recapture (at a maximum rate of 25%) in addition to the $1 million of capital gain (at long-term capital gains rates). That is a very rude awakening for most people.
Many clients approach us after they have sold their properties asking about their tax reduction options. While there are some options available, the opportunity set is expanded if we can plan before the sale is finalized.
1031 Exchange
One effective option for deferring taxation in connection with the sale of an investment property is a 1031 exchange. A 1031 exchange is relatively straight-forward, but there are distinct rules that must be followed.
Engage a Qualified Intermediary Before Closing: A qualified intermediary (QI) is a middleman in the sales process. At closing, the property is transferred to the QI and then the QI immediately transfers the property to the buyer. The QI then takes custody of the funds and holds them until you are ready and able to finalize your 1031 exchange. It is important to note that if you do take possession of the funds at closing, you are no longer eligible to explore a 1031 exchange. That is one of the reasons that it is critical to let us know beforehand. Engaging a QI provides optionality – you can explore whether you would like to proceed with a 1031 exchange at a relatively small cost, but there is no obligation to do so.
Select Replacement Property Within 45 Days After Closing: Essentially, you have about a month and a half to identify a “like property” to purchase to complete the exchange. We’ll talk about the various options in a bit, but you have to be explicit in your identification (address, amount, property description, etc.). Vague doesn’t work here.
Make Replacement Investment within 180 Days After Closing: You will need to purchase the replacement property identified in the preceding step within 180 days following the date you closed on the sale of your prior property.
Replacement Property – An Interesting Option
Identifying the replacement property is where most people tend to get hung up (assuming they had the foresight to engage a QI in the first place). The requirement is that the replacement property must be a “like” property. While many assume that “like” means “identical”, the actual definition is broader. For example, it is possible to go from an investment in a single-family home that is actively managed to an investment in a warehouse. Similarly, it is possible to go from an investment in which you have been actively involved to an investment that is more passive in nature.
One of the reasons that most people rule out a 1031 exchange from the start is that they simply do not want to actively manage another property and take on all the related headaches – tenant issues, repairs, etc.
What if there were a way to get all the tax benefits of a 1031 exchange without any of the headaches associated with managing a property? What if there were a way to also diversify your holdings – owning different types of properties in different geographies?
Fortunately, for qualified investors, there is an option that provides both benefits, the Delaware Statutory Trust (DST).
DSTs are designed specifically to comply with the rules in place for 1031 exchanges. Most offer the following features:
Monthly income
Low minimum investments
Passive ownership (no tenant calls, repair calls, etc.)
Opportunity for appreciation
Due to the low minimum investment, it is possible to invest in multiple DSTs, meaning that you can swap an investment in an office building that you were actively managing, for example, into passive ownership of an apartment building, a self-storage facility, and a healthcare facility in different locations around the country and still take advantage of the tax benefits of a 1031 exchange. Given the breadth of product, there are countless permutations depending on the exposures (property type and geography) that make sense for you.
The process of investing in a DST is also fairly easy and efficient. Once you have made the decision, the actual investment – paperwork and all - can be completed in a matter of days. Due to the beauty of systems like DocuSign, it can even be done from the comfort of your home – a true benefit given our current reality.
Wrapping It Up
1031 exchanges are a missed opportunity for many. If you have investment property that you are interested in selling and want to explore the options for deferring taxes, let us know. A DST may be a worthwhile consideration that can provide you with the opportunity to continue receiving income while removing the headache associated with having to actively manage a property.