One widely used tax strategy among real estate investors is the “like-kind” exchange, often called a 1031 exchange after the Internal Revenue Code section that allows this tax treatment. A 1031 exchange enables taxpayers to defer capital gains taxes when they sell investment or business properties. A proposal to limit such deferrals faces an uncertain future in Congress this year, but even if it is not enacted there are other circumstances that can make a 1031 exchange impractical or inappropriate.
Here is a brief overview of alternative strategies for managing the tax consequences of a property sale.
1031 Exchange Basics
Section 1031 of the Internal Revenue Code allows taxpayers to defer paying taxes on capital gains when they dispose of an investment or business property if they swap the property for another rather than selling it outright. Although Section 1031 originally applied to various asset categories, the Tax Cuts and Jobs Act of 2017 limited it to real property that is held for business use or as an investment.
Because it is rare for two property owners to agree on an even swap, almost all 1031 exchanges involve a third party. In these delayed exchanges, a qualified intermediary holds the initial sale proceeds, and later transfers those funds to the replacement property seller.
There is currently no limit on the number of times a taxpayer can make a 1031 exchange, so a business can continue rolling over its tax-deferred gains through subsequent property exchanges until it ultimately liquidates its investment. Individual taxpayers can defer gains until their death, at which time the deferred taxes are effectively erased and the property passes on to the taxpayer’s heirs with a step-up in basis.
1031 Exchange Complications
While Section 1031 applies to all types of taxpayers including individuals, corporations, and other entities, 1031 exchanges can be more difficult to manage in partnerships and other pass-through entities because the participants’ varying tax situations can prevent agreement on how much, if any, of the sale proceeds should be diverted into a 1031 exchange.
To qualify for a deferral, a 1031 exchange participant has just 45 days from the sale of the property to identify a limited number of potential replacements, and only 180 days to complete the purchase. These deadlines can put buyers at a disadvantage, forcing them to rush into a purchase to avoid losing all their accumulated tax deferrals.
1031 Exchange Strategies
To accommodate Section 1031’s rigid deadlines, some taxpayers initiate a reverse exchange, in which they purchase the replacement property before selling the original. This can be advantageous in a hot market but it poses more risk as the taxpayer must be able to fund the purchase before receiving the sales proceeds. Reverse exchanges also can incur additional transaction costs.
Rather than rushing to find a suitable replacement property within Section 1031’s time limits, many sellers instead choose to purchase a fractional interest in a property, often using a Delaware Statutory Trust (DST), an entity created specifically to hold title to investment real estate. In addition to incurring added fees, a DST investor also relinquishes significant control over the investment because the trustee ultimately decides how to manage the property, including whether and when to sell. For additional information, see Use of Delaware Statutory Trusts for 1031 Exchanges.
Alternatives to a 1031 Exchange
Beyond 1031 exchanges, there are other available strategies for deferring or reducing tax obligations from the sale of property. In an installment sale, for example, the taxpayer still pays tax on the gain, but the burden is spread out over the duration of the installment contract.
Rather than selling an investment or business property, individual taxpayers who are charitably inclined may donate it to a charitable remainder trust, naming a tax-exempt charity as the beneficiary. The trust then sells the property, reinvests the proceeds, and pays recurring income to the taxpayer until the taxpayer’s death, at which time the remaining funds are given to the charity. In exchange for the property, the donor receives a tax deduction along with a lifetime source of income.
Finally, reinvesting capital gains into a Qualified Opportunity Zone Fund (QOF) offers another way to temporarily defer capital gains taxes, but only through 2026. The deferred tax is due in early 2027, but taxpayers may permanently exclude 10 percent of the deferred gain if they hold their QOF investment for at least five years. Additionally, if they hold the QOF for 10 years, gain from the sale of the QOF would be tax-free. Unlike a 1031 exchange, a taxpayer does not need to invest all proceeds of the sale—only the gain—in order to defer the tax.
Selling a business or investment property can be challenging, with many variables and alternatives to consider. Contact us to discuss your options for managing the tax consequences of a property sale.