When real estate investors consider selling their properties after significant price appreciation, they often face a tough choice. Investors can cash in on a potentially good offer and pay the taxes, or they can continue to hold and manage the property. Certain techniques allow for a tax-free exchange (i.e., 1031 exchange) of real estate property. However, most of these techniques have historically come with various drawbacks. A recent improvement in the investment options for tax-free real estate exchanges now may allow investors to sell their property, defer (or avoid) taxes, and maintain completely passive ownership of an institutional quality, diversified real estate portfolio.
1031 Exchange Basics
The 1031 exchange allows investors to defer taxes from the sale of real estate investment properties. Investors must follow a few 1031 exchange rules to qualify for the tax deferral.
The replacement property that the investor acquires must be “like-kind” to the relinquished property. The term “like-kind” has a broad definition. The replacement property does not have to be in the same asset class or geographic location. Investors must hold like-kind properties for a productive use in a trade, business, or investment (i.e., primary residences and vacation homes do not qualify). If the IRS determines that you hold property primarily for (re)sale instead of for investment, that property won’t count as like-kind. Simply put, a property held for sale or resale is one bought just to be “flipped.”
Second, the total value of the replacement property must be equal to or greater than the total value of the relinquished property to avoid capital gains taxes altogether. Investors also must maintain a similar or larger amount of equity invested in the replacement property. Investors exchanging properties of comparable value and who used debt on their original property will need to use an equivalent amount of debt or invest more cash with their replacement property.
The ownership title for the replacement property must be identical to the title for the relinquished property. Investors can hold title to their replacement property via pass-through entities, such as single-member LLCs and even Delaware Statutory Trusts (DSTs) with multiple investors.
Lastly, the IRS has specific rules and timelines that investors must follow to qualify for the tax-free exchange. Before signing a sales agreement, investors interested in pursuing a 1031 exchange should work with a qualified real estate attorney.
1031 Exchange Like-Kind Property Options
The most common type of like-kind property exchange is when investors swap one or more real estate properties for one or more real estate properties that the investor will continue to own and operate. The problem with this solution is that the investor still is responsible for managing the property, and their overall investments might be concentrated in a small number of properties, likely in the same geography and asset type (e.g., residential or office). Many individual real estate investors overlook the risks posed by concentrating one’s assets in a small number of properties.
Delaware Statutory Trusts (DSTs) are an example of alternative replacement property options that an investor can use as the like-kind property to defer taxes and allow passive ownership.
Using the 1031 exchange rules, an investor exchanges proceeds from the sale of their relinquished property for an interest in a DST, which itself owns one or more real estate properties. The DST entity allows multiple investors to pool their money to own a fractional interest in institutional quality real estate (i.e., warehouse building leased to Amazon vs. duplex rented to students). Unlike directly owning real estate, by holding a fractional interest in real estate via the DST, the investor passes the burdens of management on to the DST sponsor.
However, DSTs are illiquid investments and can have long, uncertain holding periods. When the DST sponsor sells the property after several years, the investor needs to complete another 1031 exchange to continue the tax deferral of their capital gains. Given that the investor does not control the timing of the exit, they are exposed to a regulatory risk that future legislative changes may restrict or eliminate 1031 exchanges, thus forcing the investor to pay the deferred taxes. The investor also may need to continue paying DST fees on every transaction, which can be high.
721 Exchanges (UPREIT)
A 721 exchange (also known as umbrella partnership real estate investment trust/UPREIT) is like a 1031 exchange. It allows a real estate investor to defer capital gains tax on selling a real estate investment property. One key distinction of the 721 exchange is that it enables investors to exchange like-kind property for operating partnership units of a broadly diversified REIT.
Until recently, owners of non-institutional real estate properties most likely would have been prohibited from completing a tax-free exchange into a broadly diversified REIT. Today, a few real estate managers allow individual real estate investors to complete a 1031 / 721 exchange combination into their diversified real estate fund with minimum investments starting at $500,000. Investors can own the diversified real estate indefinitely as part of their overall investment strategy, which will allow them to defer the capital gains tax from their original real estate investment.
Under the current estate tax laws, when someone passes away, their assets receive a step-up in basis, so the deferred tax liability goes to zero. At that point, the investor’s estate can sell the real estate investment fund and distribute the funds to their beneficiaries without any income tax implications.
The above table summarizes the characteristics of the tax-free real estate exchange replacement options discussed in this post. With any tax-free real estate exchange, you must consult an attorney and accountant before beginning the process of selling your current property. Please get in touch with our team to learn how a tax-free real estate exchange into a diversified REIT fund might fit into your investment strategy and financial plan.