What Is a 1031 Exchange?
A 1031 Exchange allows a property owner to defer the capital gains tax on the sale of real estate as long as the proceeds are used for the purchase of a replacement property. By allowing an investor to use 100% of the untaxed proceeds from a property sale to buy new property, a 1031 Exchange is both an efficient and effective method to preserve capital, readjust a portfolio, and invest in a new property.
But how does a 1031 Exchange work? There are three main steps to the process:
1. An investor must decide it is most beneficial to their financial future to sell their property and defer capital gains taxes by entering into a 1031 Exchange.
2. The owner must sell the property. To qualify for a 1031, an investor cannot take receipt of the proceeds—it must be held by a Qualified Intermediary until a new property is purchased.
3. Identify a new property. The most common 1031 Exchanges are “delayed exchanges,” which gives the investor 180 days to close on a new property to complete the exchange. To qualify for the tax deferment, investors must reinvest the entirety of the proceeds from the initial sale and acquire real estate with the same or greater amount of debt (leverage).
There are several benefits to entering into a 1031 Exchange including:
- Eliminating the financial burden of active ownership and management of a property
- Exchanging a revenue deficient property for a revenue rich property
- Diversification of real estate portfolio
- Possible ownership in high-grade commercial properties (DST)
Additionally, the revenue earned from the sale of a property within a 1031 exchange can be held indefinitely. An investor can choose to make any number of 1031 exchanges before finally selling outright, at which point capital gains taxes must be paid.
Another popular option for those looking to enter into a 1031 Exchange is to utilize the provisions of a Delaware Statutory Trust (DST). DST’s not only qualify under the guidelines laid out for a 1031 Exchange, but can also simplify the process of identifying properties in the time allotted to successfully complete the exchange.
A DST can hold any type of real estate class, be it a multi-family apartment complex, a massive pharmaceutical campus, student housing, or a sprawling shopping center. DST’s are a great option for investors to take their tax-deferred proceeds from a property sale and invest in a more diverse range of real estate opportunities with virtually zero property management responsibility. By using a 1031 Exchange to invest in a DST, investors are able to purchase a fractional interest in a large, institutional-quality, professionally managed commercial property as individual owners within a secure and flexible trust, with possible less risk and more diversification.