Skip to main content

1031 Exchange Alternatives

June 22, 2023

A 1031 exchange is a well-known tax deferral strategy. It is a provision within the United States Internal Revenue Code Section 1031 that offers taxpayers an opportunity to defer capital gains taxes on a property only if the proceeds from the sale of the property are reinvested in a “like-kind” property of the same value or more. However, this is not the only real estate tax deferral strategy. In this article, we look at alternative 1031 exchange strategies an investor can use in their real estate investment journey to defer their capital gains tax burden and maximize investment returns.

What is a 1031 exchange?

What is a 1031 exchange?

A 1031 exchange is a tax deferral strategy for capital gains taxes on investment property. Before discussing the alternatives to a 1031 exchange, let’s first start by familiarizing ourselves with the relevant information about 1031 exchanges themselves. Here are the main things you need to know:

Eligible properties: For a property to qualify for a 1031 exchange, both the relinquished property (the property being sold) and the replacement property (the property being acquired) must be for investment purposes, trade, or business. Personal property does not qualify for 1031 exchanges as of January 1st, 2018, after implementation of the Tax Cuts and Jobs Act’s (TCJA) 2017 tax law.

Qualified Intermediary (QI): To have a seamless 1031 exchange process, you must engage a neutral third party, also known as a Qualified 1031 Exchange Intermediary who is well-versed with the IRS regulations and compliance. A QI assumes the role of coordinating the entire exchange process.

Timing requirements: The 1031 exchange is regulated by strict timelines that must be adhered to succeed.

Acquisition period: Once the potential replacement property or properties has been identified, the taxpayer has 180 days from the date of selling the relinquished property or properties to close on the replacement property with the help of a QI.

Tax deferral: By undertaking this journey with the help of a QI, a taxpayer can defer capital gains tax. The tax liability remains suspended pending a future taxable event.

1031 Exchange Alternatives

1031 Exchange Alternatives

There are situations where investors can explore alternative approaches that fulfill their investment objectives while managing their tax liabilities differently. Here is a breakdown of the available 1031 exchange alternatives.

1. Deferred Sales Trust (DST)

A Deferred Sales Trust is a popular tax deferral strategy. In this scenario, a property owner chooses to entrust a trust with the property. The Trust then sells the property and holds the proceeds. The property owner agrees to a payment plan for receiving payments from the trust over time. During this period, the trust invests the proceeds to generate income that is given to the property owner according to the payment plan. The owner pays taxes on income received, spreading out the tax payments over a long period of time. By doing this, the property owner gains the flexibility to manage their tax liabilities more efficiently.

2. Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts are investment vehicles that enable individuals to participate in the real estate market without the need for direct ownership or property management responsibilities. Instead of an investor selling the relinquished property to an individual, the investor contributes the property to a REIT in exchange for shares. This transaction is referred to as the “721 exchange”. The investor sells the property to a subsidiary of the REIT known as an Operating Partnership (OP), and in turn, the investor gets several OP units that can be converted into REIT shares. The investor then receives dividends from the shares up until the time the investor is ready to sell the property and incur capital gains taxes.

3. Opportunity Zones

Opportunity zones

The Tax Cuts and Jobs Acts of 2017 to promote development in economically distressed areas also known as Opportunity zones established economic vehicles called Qualified Opportunity Funds (QOFs)

Opportunity Zone investments present unique opportunities for accredited investors to contribute to the economic growth of designated low-income communities.

After selling the relinquished property an investor can reinvest their capital gains into QOFs, and by doing so, they can potentially defer or reduce their capital gains taxes.

Investors are rewarded with major tax benefits and incentives for directing capital into these opportunity zones.

If an investor sells relinquished property and directs the funds into a QOF, and holds the investment for more than 10 years, the investor is likely to be exempt from the capital gains taxes.

With this alternative investors can not only defer capital gains taxes they can potentially be exempt from paying capital gains taxes.

4. Delaware Statutory Trusts (DSTs)

This is a trust formed under Delaware law by a professional real estate firm. The real estate firm finds a suitable property and manages the due diligence, day-to-day logistics, and management of the property. Individual investors purchase shares in the DST to gain fractional ownership of the underlying property. The investors then get taxable income in the form of dividends. The IRS Revenue Ruling 2004-86 states that a DST investment is an eligible replacement property in a 1031 exchange. An investor could achieve tax deferral by selling a property and investing the proceeds into a DST investment instead of purchasing a suitable replacement property outright while still wanting to generate consistent income.

Comparing 1031 Exchange Alternatives: Key Considerations

Comparing 1031 Exchange Alternatives: Key Considerations

When deciding on which 1031 exchange alternatives are right for your investment strategy there are a few factors to consider as an investor.

Risks and Rewards

Understanding the risks and rewards that come with every 1031 exchange alternative is very vital. Here are a few factors to keep in mind:

  • Income generation: Consider the potential income yield that comes with every alternative. How much potential income is each alternative likely to generate for you, and does it align with your investment objectives?
  • Growth and Appreciation: How much income is each alternative likely to generate in the long term, and what would be the growth rate of that income over time? What is the potential for property appreciation over time?
  • Liquidity: What liquidity options does each alternative provide? And do the options align with your investment objectives?
  • Management Involvement: Does each alternative require management of the properties, and if so, to what extent?

Tax Implications

Considering the tax implications that come with every alternative is crucial. Here are the factors to keep in mind: Does the alternative have tax deferral on capital gains, and if it does, how does a taxpayer go about it? What is the tax efficiency of each alternative? As we have seen above, tax benefits vary depending on the alternative you choose.

Liquidity and Accessibility

Evaluate the liquidity options for each alternative. What is the accessibility and investment size required for each alternative?

Investor Control and Flexibility

What level of control do you have over your potential investments as a potential investor? And how flexible is the control you have? Different alternatives have a different level of control and involvement by the investor. It is up to you to choose an alternative that has a level of control and flexibility that aligns with your investment objectives.

Potential Drawbacks of a 1031 Exchange

Potential Drawbacks of a 1031 Exchange

In investment decisions, understanding the limitations and challenges associated with a 1031 exchange plays an important role in empowering investors to make well-informed decisions. Here are some potential drawbacks of a 1031 exchange.

Property Like-Kind Restrictions

This restriction of the replacement property should be like-kind as the relinquished property limits the number of eligible properties a taxpayer or accredited investor can identify and potentially invest in. This is a potential hurdle, especially for an investor looking for real estate assets to diversify their portfolio.

Potential Tax Risks

The whole allure of the 1031 exchange is the ability to defer capital gain tax. However, this tax-deferred exchange is a very different concept from the absolute exemption from paying capital gains taxes. With tax consequences of this deferral always looming in the background, it is up to the taxpayer to monitor and navigate tax regulations. A future taxable event that entails the sale of the replaced property without executing another 1031 exchange will trigger the revival of the deferred tax liability.

Complexity and Legal Compliance

The 1031 exchange has an intricate set of rules and regulations that must be navigated with the utmost care and precision for the exchange to be successful. There must be a thorough understanding of the applicable various tax code, laws, deadlines, procedural guidelines, and legal frameworks. Failure to comply with the guidelines can not only lead to the potential disqualification of commercial property from the exchange but can also lead to the imposition of hefty tax burdens. Also, identifying potential replacement properties that comply with the like-kind requirement can be quite a challenge.

Why Seek 1031 Exchange Alternatives?

Aside from the potential drawbacks above, there are a few other factors that can prompt a taxpayer to seek 1031 exchange alternatives.

Time constraints: The 1031 exchange process works under very strict timelines. One is the 45-day identification rule from the day of selling the relinquished property, and the other is the 180-day purchase rule from the day of selling the relinquished property. The two go hand in hand. Both the identification and the acquisition of real property can prove to be very hectic and difficult, especially when working with strict timelines in a competitive real estate market.

Cash flow needs: A 1031 exchange entails reinvesting the proceeds from the sale of a relinquished property into a replacement property. However, if liquidity and cash flow take precedence over acquiring property, then the 1031 exchange will prove to be a futile strategy.

Depreciation recapture: In a 1031 exchange, the deferred capital gains tax is typically transferred from the relinquished property to the replacement property. If depreciation is captured in the relinquished property, it must be recaptured, and therefore the taxpayer is likely to incur a depreciation recapture tax. The impact of this recaptured depreciation tax liability on the overall tax advantages of a 1031 exchange can be significant. Prompting taxpayers to seek other 1031 exchange alternatives.

Diversification of Portfolio: Since the 1031 exchange helps investors defer capital gains tax on like-kind properties, this approach may limit investors when it comes to diversifying their portfolios as compared to other 1031 exchange alternatives like Real Estate Investment Trusts (REITs) and DSTs, which we will breakdown in this article.

Conclusion

The 1031 exchange has been a popular tax deferral strategy among investors. However, there are numerous alternative options that offer comparable benefits and cater to different investment preferences. These alternatives comprise of Delaware Statutory Trusts (DSTs), Deferred Sales Trusts (DST), Opportunity zones, Real Estate Investments Trusts (REITs), and other viable choices. By providing Investors with flexibility, these alternatives enable them to select options that align with their goals, risk tolerance, and financial objectives.

Through a comprehensive exploration of these alternatives coupled with a thorough understanding of their advantages and considerations, investors can make well-informed decisions and optimize their real estate investment strategies, potentially minimizing tax liabilities along the way.

 

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.