Experience shows that a 1031 exchange is a great vehicle to create generational wealth, however they aren’t typically for the weak of heart. There are complications and timelines that must be adhered too. Let’s look at some of the benefits:
- You can transfer a larger property into multiple smaller properties
- You can transfer multiple smaller properties into a larger property
- You can sell/purchase anywhere in the United States (Relocation opportunities)
- You start the depreciation process over when you purchase a new property
- You can transfer a specific kind of property into another kind of property
- You can diversify your property portfolio
- And so many more...
Let me give you a few examples. Let’s say that you have a 100-unit apartment building that you have owned for 20 years. Chances are very likely that the property has gone up significantly in value, while the property may have depreciated and declined in quality... the neighborhood may have gentrified, rents increased and yet the rent increases haven’t kept up with other areas/neighborhood and a myriad of other examples.
In these scenarios a 1031 exchange will allow you to divide that one 100 unit building into another building, or 10 buildings,a commercial building, retail center, land, etc., and the opposite holds true as well. You have 5 rental properties consisting of condos, single family and a multi-unit property and you can exchange out of these into 1 much larger building. Once you have purchased your replacement property you can start the depreciation on the building/property all over again. While many may say that this isn’t a reason to do a 1031 exchange, it doesn’t hurt. There could be great financial benefits to taking advantage of this. Oh, and by the way... if you depreciated the previous property, the exchange bypasses the recapture of funds that you would owe the IRS upon a traditional sale, and this could be tens of thousands of dollars! (Check with your accountant and financial adviser to confirm).
Relocation or future relocation is another great reason. If you own income property here in California, we can probably agree that the tenant/landlord laws are ever increasing in the tenant’s favor. If you have an exit strategy to eventually leave the state when you retire, you can start moving your properties into states that are more landlord friendly, no tax or lower tax states, or states that you are eventually going to relocate too. How about this scenario... you own a rental here, and your child is going to go to school in Virginia. Would it make financial sense to sell your rental here... purchase in Virginia, lease the property back to yourself/your child and possibly some of his/her roommates for the next couple of years? I don’t know... maybe it would!
While I haven’t covered every benefit those are a few that don’t stink.... What about the downsides to a 1031 exchange. Here are a few things to consider:
- The time frames are NOT flexible or forgiving
- Your property tax base is NOT transferable
- You don’t have liquidity
- There is the risk the market will decline
- There is ALWAYS a COST OF SALE!!!
- A 1031 exchange can seem overwhelming and complex
Let’s look at some of these in detail. The time frames to stay withing are NOT flexible or forgiving in that they are very black and white. According to the IRS, the replacement property/properties must be identified in 45 days and MUST close escrow in 180 days. With inventory as low as it is right now, this could create complications in the ability to find a great replacement property, and you could find yourself making sacrifices or purchasing a property that is less than ideal.
Your property tax base is lost and gone forever. If you purchased a rental property for $100,000 and it’s now worth $400,000, it’s likely that with proposition 13, your tax base could be under $250,000. The replacement property has to be equal to or greater than the sales price (if not, you are subject to taxable gains on what is referred to as Boot, and that is a conversation for another day), so your tax liability will now increase to the new sales price at the effective rate of the county that you are purchasing in... this could have a significant impact on your cash-flow and P&L at the end of the year. You don’t have liquidity... For the most part that is. You still have access to borrow against your equity and yet this would be at a higher-than-average interest rate. Let’s be honest... are you going into the property investment business for liquidity? Nah... but you may want to have some liquidity in your portfolio, and real estate isn’t always liquid.
Jeff... what about a market shift? Yes, it could happen. We’ve been riding the wave of appreciation for a long time. If the market were to adjust, you could lose substantial equity in your investment. Yep... I said it. And... I will tell you that Real Estate is a long game. Your plan should always be to leave your funds in the market for as long as you are financially able. If you are planning on being in the investment vehicle for more than 10 years... I wouldn’t typically be too concerned about the market decreasing/increasing.
There is ALWAYS... ALWAYS... an out-of-pocket cost of sale with an exchange. There could be commissions, there are escrow and title fees, transfer fees, prorated items, etc... there is always a cost of sale, and you should look at what that will be and how that will have an impact on your investment in the long run. If someone says, there is NO out of pocket fees... just stay curious and ask more questions. These transactions could be complicated and overwhelming, and yet the right agent with the right mentality, information and experience can guide you through the turbulence and see you through the storm. If you or someone you know, like and care about are considering a 1031 Exchange, please feel comfortable reaching out as I’m here to help. Until then... stay well and stay informed!
