A 1031 exchange — named after Section 1031 of the Internal Revenue Code — is one of the most powerful tools available to real estate investors. It allows investors to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into a like-kind property.
Key benefits of a 1031 exchange
The primary benefit of a 1031 exchange is the potential to defer taxes associated with selling real estate, including federal capital gains, state income, and depreciation recapture. Unhindered by immediate tax liabilities, investors can enjoy increased buying power and greater portfolio value.
Importantly, investors can defer these taxes indefinitely—there is no predetermined date at which the taxes become due. As such, many investors complete several exchanges over the course of their lifetimes, “exchanging up” into one real estate asset after another.
Upon the taxpayer’s death, their heirs receive a huge benefit: A step-up in basis to fair market value, which potentially eliminates deferred taxes. This feature makes 1031 exchanges a very advantageous estate planning tool and has inspired the “swap ‘til you drop” mantra.
A simple example of a 1031 exchange
As a hypothetical illustration, let’s say Jennifer owns a commercial building that’s currently worth $3 million, double what she paid for it four years ago. She wasn’t planning to sell until her real estate broker told her about a large condominium located in an area with increasingly higher rents that’s on the market for $4 million.
By using a 1031 exchange, Jennifer could sell her commercial building and use the proceeds to help pay for the bigger replacement property without having to worry about the tax liability now. She is effectively left with extra money to invest in the new property by deferring capital gains and depreciation recapture taxes, as these taxes would have been due if she took the sales proceeds.
Swapping into a DST or TIC
Many taxpayers exchange into full ownership of another investment property—as described in the example above—while others choose to swap into a Delaware Statutory Trust (DST) or tenant-in-common (TIC) arrangement. DSTs and TICs can offer investors fractional ownership options compatible with 1031 exchanges.
By exchanging into a DST or TIC, investors have the opportunity to generate passive income as they hand off management responsibilities to a professional sponsor. These investments can also help taxpayers access institutional-quality real estate, given their pooled nature, and can be an effective means to achieve greater diversification.
1031 exchange rules and regulations
To successfully complete a 1031 exchange, investors need to adhere to a substantial set of rules and regulations. Investors benefit significantly from engaging experienced tax, legal, and financial advisors to ensure compliance and optimize benefits.
Important guidelines include:
- Like-kind exchange – Taxpayers must exchange real estate assets used for business or held as an investment for other business or investment property that is the same type (“like-kind”). Notably, this does not mean the properties must be in the same asset class; for example, investors can exchange a multifamily building for an industrial property, or swap a retail building for a self-storage facility.
- Timelines for property identification and exchange completion – Investors must meet two-time limits: identify potential replacement properties within 45 days from the date of sale, and complete the exchange within 180 days.
- Same taxpayer – The taxable entity relinquishing a given property must be the same entity buying the replacement property.
- Value considerations – The replacement property must be of equal or greater value than the relinquished property. Any difference in value will be taxable. If there was outstanding debt on the relinquished property, it must be replaced on the new property or cash must be added to the exchange to equal the amount of debt.
- Qualified intermediary – Taking control of cash or other proceeds before the exchange is complete may disqualify the transaction. To avoid this problem, investors use a qualified intermediary or other exchange facilitator.
For investors swapping into DSTs or TICs, additional guidelines apply.
Important considerations
- Strict timeline restrictions – Having only 45 days to identify a property and 180 days in total to close on the replacement property can create challenges. The ticking clock can lead to hasty decisions and major headaches if there are delays in any step of the process. For example, with only 45 days to identify a property, some investors could feel pressured to overpay for a property to make sure they meet the deadline.
- Complexity and need for experts – 1031 exchanges are complex transactions that require attention to detail and a clear understanding of the rules. Any missteps in the process can negate the transaction and lead to unintended consequences, including immediate tax liabilities.
- Deferral, not elimination, of tax – 1031 exchanges allow for tax deferral, but not an elimination. The taxes will come due once the replacement property is sold, unless another 1031 exchange is performed.
- Lack of liquidity – Since all of the proceeds in a 1031 exchange need to be invested in the replacement property, there is usually no way for investors to access that capital without having a tax consequence.
- Market risks – 1031 exchanges can experience the same market risks as any other real estate project, including recessions, high interest rates, and other factors.
Caliber’s 1031 exchange offerings
We connect investors with optimal 1031 exchange assets for reinvestment. Our full-service solution is for accredited investors seeking to invest $1M+ in commercial real estate assets through a tailored 1031 exchange. Investors can exchange their assets for professionally managed, high-quality real estate that offers the potential for capital appreciation alongside regular distributions.
Learn more about our 1031 exchange program.
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About Caliber (CaliberCos Inc.) (NASDAQ: CWD)
With more than $2.9 billion of managed assets, including estimated costs to complete assets under development, Caliber’s 15-year track record of managing and developing real estate is built on a singular goal: make money in all market conditions. Our growth is fueled by our performance and our competitive advantage: we invest in projects, strategies, and geographies that global real estate institutions do not. Integral to our competitive advantage is our in-house shared services group, which offers Caliber greater control over our real estate and visibility to future investment opportunities. There are multiple ways to participate in Caliber’s success: invest in Nasdaq-listed CaliberCos Inc. and/or invest directly in our Private Funds.
Investor Considerations
The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances, desires, needs, and requires consideration of all applicable facts and circumstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.
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