Clearly, 2020 was a year unlike any other as the multifamily housing industry struggled through a global pandemic, disruptive new regulation, and a divisive presidential election. Impacted by extending eviction bans and escalating delinquencies, many rental property owners have explored 1031 Exchanges as a way out.
If you are thinking about selling your rental property in 2021, a tax-deferred 1031 Exchange may be a path to consider. Here are six frequently asked questions we received from rental property owners about 1031 Exchanges and investment options in 2020
Reducing tax liability on relinquished investment property is certainly the most well-known benefit of a 1031 Exchange. This allows investors to defer tax on capital gains and depreciation recapture and acquire replacement properties at pre-tax dollars.
A 1031 Exchange also introduces several lesser-known exchange benefits depending upon the ownership structure of the replacement property. Exchanging into Delaware Statutory Trust (DST) or Triple Net Lease (NNN) properties, for example, enables investors to “trade up” and fractionally own institutional-grade real estate with higher income potential.
As popular passive real estate alternatives, DST and NNN properties also allow investors to eliminate active management responsibilities and diversify risk by exchanging into multiple properties and various asset types and geographical markets.
A 1031 Exchange into DST properties is also a powerful estate planning tool. The capital gains tax can be eliminated altogether on replacement property inherited by heirs as the “stepped-up basis” of the property will be equal to its fair market value on the date of your passing.
Both democrats and republicans have threatened to eliminate the 1031 Exchange provision in recent times, making this a great question to examine regardless of who holds office. Biden’s plan would eliminate the use of 1031 Exchanges for real estate investors making over $400,000 in annual income and eliminate the step-up in basis for assets acquired from a decedent.
Several respected economists have studied the impacts of the Biden proposal and the results are far from favorable for Americans. “Raising the capital gains (tax rate) and eliminating 1031 would create a 20 percent decline in commercial real estate values. Real estate would be subject to the capital gains tax at a very high rate,” said Ken Rosen, chairman of Rosen Consulting Group and the Fisher Center for Real Estate and Urban Economics at the Haas School of Business at the University of California, Berkeley.
While eliminating the 1031 Exchange may appear to boost tax revenue on the surface, in reality, it could have far-reaching detrimental effects on the commercial real estate industry and economy. These impacts include a significant decrease in real estate investment, transaction volume, liquidity, and property values – ultimately decreasing property taxes, jobs, and government revenue. The outcome of Biden’s proposal to eliminate the 1031 Exchange is unknown and could disappear quickly or continue to evolve. We believe changes are unlikely, but the proposal is something that should be closely monitored.
The COVID-19 global pandemic has wreaked havoc across most commercial real estate sectors, including office, hospitality, multifamily, restaurant, personal services, entertainment, and construction. Public health measures have severely impacted landlords with extended eviction bans and increased delinquency. As COVID-19 transmission rates remaining high across many states, the financial impacts on investment property owners are projected to continue well into 2021.
Despite the short-term downturn, we are still very bullish on long-term commercial real estate however, too much concentration in any one market/market sector puts preservation of capital at risk. Investment property owners who are entirely concentrated in one property type, or in one geographic area, such as multi-family rental property should consider diversifying a portion of their portfolio. Within real estate, different geographic locations and different property types, serving different business sectors, behave differently to major events and market cycles. We believe diversification is key when focusing on preservation of capital. A 1031 Exchange into Delaware Statutory Trust (DST) properties, for example, enables investors to help diversify risk by exchanging into multiple properties and various asset types and geographical markets with fractionally owned, institutional-grade real estate.
Identifying a suitable replacement property can be a challenging and stressful decision. Several factors must be carefully considered when seeking to achieve the exchanger’s financial and lifestyle goals, including tax liability, ownership structure, property location and attributes, and overall market dynamics. Understanding your tax liability and setting financial and lifestyle objectives is a critical first step. These objectives should be based on what you are looking to accomplish today and well into the future. Key factors to consider include risk tolerance, cash flow, appreciation potential, liquidity, management control, and estate planning needs.
Most of our clients, for example, have owned and managed rental properties for several years. They are ready to retire and want to avoid taxes on capital gains when selling their highly appreciated properties. For these risk-averse investors, transitioning away from active property management and into passive real estate with high-income potential is highly desired. A 1031 Exchange is also an important estate planning tool to minimize capital gains tax when the replacement property passes to their heirs. To completely defer taxes, the replacement property must be at a value that’s equal to or greater than your original property’s sale price. In our example above, the fractional ownership structure of Delaware Statutory Trusts (DSTs) and Tenant-In-Common Properties (TIC) offer the income potential, risk diversification, and passive management our clients are seeking.
Although 1031 Exchanges are very popular and have many benefits, they may not be suitable in certain situations. That is why it is important to first determine whether an exchange is the right decision and should be based on your objectives, financial situation, and tax liability that would result from selling your investment property. This is because tax liability not only includes gains taxes but is also impacted by other income, other asset sales, and any unused loss carryforwards. As a result, your total tax liability could be substantial depending on which state you live in. For example, investment property owners in California can pay as much as 42.1% in tax on the sale of investment property.
To determine if a 1031 Exchange is suitable for you, schedule a free consultation with a 1031 Exchange professional at Real Estate Transition Solutions to discuss your situation, objectives, and potential tax liability. Our consultations are informal and can be done via phone, via web conference, or in person at one of our offices. To schedule your consultation, call 206-686-2211 or email us at firstname.lastname@example.org.
Once you have made the decision to perform a 1031 Exchange, your first step should be to select a 1031 Exchange firm to ensure your exchange is successful and to guide you through the exchange process. Below are a few key steps when getting started with a 1031 Exchange. For a more comprehensive understanding of steps, visit our website at www.re-transition.com and download our free guide: Understanding 1031 Exchanges.
Step 1: Select a 1031 Exchange Firm. A good 1031 Exchange firm should not only help you find, select and acquire a 1031 Exchange qualified replacement property, but should also assist you in navigating the exchange rules, debt matching considerations, and unravel property ownership issues. There are quite a few 1031 Exchange companies to choose from, however, like any industry, the level of expertise, years of experience, client-focus, due-diligence, and services offered vary greatly from company to company.
Step 2: Identify potential 1031 replacement property (45-Day Rule). This step must be done within 45 days after closing on your relinquished property so it’s a good idea to work with your 1031 Exchange firm early on to identify suitable replacement properties.
Step 3: Enter into a contract to sell your existing investment property. Work with your realtor/broker to get your existing investment property (Relinquished Property) listed and under contract.
Step 4: Select a Qualified Intermediary (QI) and open an Exchange. Once your Relinquished Property is under contract, the next step is to open an exchange with a Qualified Intermediary. Required by the IRS, a qualified intermediary is the entity that holds onto the Exchange proceeds while your Replacement Property is identified and releases the funds to acquire the 1031 Exchange replacement property. Note – The exchange must be opened with your qualified intermediary BEFORE the close of the sale of your relinquished property. Your qualified intermediary must also be notified of the identified replacement property.
The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Such offers are only made through the sponsors Private Placement Memorandum (PPM) which is solely available to accredited investors and accredited entities. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million dollars exclusive of primary residence) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Diversification does not guarantee profits or guarantee protection against losses. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Aurora Securities, Inc. (ASI), Member: FINRA/SIPC. Advisory services offered through Secure Asset Management, LLC (SAM), a Registered Investment Advisor. ASI and SAM are affiliated companies. Real Estate Transition Solutions (RETS) is independent of ASI and SAM.