Why Use The IRC 1031 Exchange?

By R.W. Bowlin

As real estate investors, we are continually looking for ways to maximize a property’s cash flow and return on equity.

One way to do this is to increase the leverage on a property as long as the cost of capital (interest rate) is sufficiently below the property’s Cap Rate.

Another method is to “buy up” to a larger property. The key to this strategy is to employ a tax-deferred exchange (1031) when repositioning your investment portfolio.  Instead of paying tax on the gain and recapture of depreciation, this defers the tax keeping these dollars working for you - essentially creating an interest-free loan from the government as long as investment real estate continues to be held. The Internal Revenue Code section 1031 allows investors to do just that!

The popularity of 1031 exchanges rests primarily in its ability to preserve one’s equity invested in real estate and allows investors to purchase higher value properties or multiple properties with the tax-deferred proceeds from their relinquished property. Utilization of a 1031 exchange allows investors to defer both the long-term capital gains of 15% or 20% (depending on one’s annual income) plus any state level capital gains, as well as the Net Investment Income Tax of 3.8%. However, it should be noted there are both pros and cons to utilizing a tax-deferred exchange, a sampling of which are detailed in the below:

Pros:

  • Deferral of Capital Gains & Net Investment Income Tax

  • Possible increase in cash flow due to preservation of equity

  • Opportunity for change in real estate type (retail, office, multifamily, NNN, etc.) as well as undivided fractional ownership structures

  • Step-up in basis upon death of property owner for their heirs

Cons:

  • Real estate exchanged into is inherently illiquid

  • Exchanges are inherently complicated, improper execution may lead to paying tax

  • Eventually tax will need to be paid if exchanged property is sold and not exchanged continuously

You may be asking yourself - why would the federal government allow such an investor-friendly ‘section’ to be included in the Internal Revenue Code? The history of IRC 1031 began nearly 100 years ago, when tax-deferred exchanges were first mentioned in the Revenue Act of 1921. At that time, it was not uncommon for property to be traded for other property. Due to the fact that monetary value was difficult to establish when cash consideration was not present, the exchange was not considered to be a taxable event. Soon thereafter, in 1924, the code was amended to allow only ‘like-kind’ exchanges, eliminating tax deferral when exchanging stock or personal property for real estate. Very few updates were made to the exchange code until 1984. Over the next 30 years, the code has been clarified and slightly modified to allow for Forward Exchanges, Delayed Exchanges, and exchanges to and from both Tenant-In-Common (TIC) and Delaware Statutory Trust (DST) ownership structures.

Over the 10 years between 2004 and 2013 nearly $3 billion of property has been exchanged using IRC 1031, of which $1.9 billion was exchanged by individuals.  These statistics are according to the most recent data available from the IRS’ Statistics of Income Division.

Tax-deferred exchanges can be applied in a number of situations depending on the property owner’s investment objectives.

Perhaps the most common scenario in which we assist investors is restructuring their real estate portfolio to simultaneously reduce active management, increase cash flow and provide both real estate property type and geographical diversification.

If you are interested in learning more about opportunities resulting from tax-deferred exchanges and the various replacement property options available to meet both your financial and personal lifestyle objectives, you can contact us at RWBowlin@RE-Transition.com - we are available to address your specific objectives while explaining how your portfolio can be positioned to meet your goals.

**This article was published in the February 2017 - RHAWA "Current" the monthly publication of the Washington Rental Housing Association.