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The Everything Guide to the 1031 Exchange in Multifamily Investing
1031 exchanges allow a commercial property owner to sell an asset and use the equity to purchase new property, with 100% of capital gains taxes deferred.
- Understanding 1031 Exchanges
- 1031 Exchanges and the Depreciation/Appreciation of Multifamily Properties
- How to Perform a 1031 Exchange
- Considerations Before Executing a 1031 Exchange
- Replacement Property Criteria
- Determining What Like-Kind Looks Like in a 1031 Exchange
- Property Titles
- The Reverse Exchange
- The Right Time to 1031
- How Deferred Capital Gain Works
- How to Avoid Disallowing a 1031 Exchange
- An Intermediary Party Is Required
- Utilize a Reverse Exchange When Necessary
- Be Mindful of Boot
- Financing a 1031 Exchange
- Using Leverage to Improve Cash on Cash
- Benefits of Leverage in 1031 Exchanges
- Replacing Debt in a 1031 Exchange
- Crowdfunding for Multifamily and Commercial Real Estate
- The Delaware Statutory Trust
- Leveraged 1031 Exchanges for Apartments
- Related Questions
- Get Financing
Understanding 1031 Exchanges
Understanding the ins and outs of 1031 exchanges provides a huge benefit to apartment investors. In the most simplified of explanations, a 1031 exchange allows a property owner to sell an asset and use the equity to purchase new property, deferring all capital gains taxes.
Essentially, in deferring capital gains tax obligations, investors are able to use the government’s due tax dollars for real estate investment and earn the return on that capital without having to pay anything to the government besides the actual tax obligation owed whenever, in the future, the investor chooses not to exercise their right to a 1031 exchange.
The key benefit of the 1031 exchange — and what makes it different from the standard sale of an asset — is found in the fact that the transaction is an exchange and not a sale. The exchange of one property for another allows for the taxpayer to avoid the tax of the “sale”, and qualify for deferred capital gain treatment.
Simply selling an asset reduces an investor’s buying power — asset sales can be taxed beyond 20% or even 30%, based on federal and state tax rates. These taxes essentially make it so that the total profit of the sale of a property could be reduced to 70% or 80% of its original worth.
1031 Exchanges and the Depreciation/Appreciation of Multifamily Properties
A 1031 exchange is perfect for investors with multifamily properties that have either appreciated or depreciated significantly.
If your multifamily building has depreciated significantly to the point of being ineligible for annual depreciation deductions on tax returns, your multifamily property’s annual returns have depreciated as well, indicating a need for a change in property so as to maximize investment dollars.
In the case of appreciation, if the apartment property itself has reached, or is close to reaching maximum appreciation, it may prove more beneficial to exchange for a new property that has greater upside potential. This strategy is particularly useful in a low interest rate environment, wherein the investor can exchange the asset for more property, with increased income and potential long-term appreciation at a lower cost than historically normal (due to the low interest rate environment).
How to Perform a 1031 Exchange
When determining how to perform a 1031 exchange, there are specific guidelines the IRC Code puts forth.
A successful 1031 exchange will require seven things:
1. The properties up for exchange must be like-kind (i.e. an apartment building for an apartment building).
2. The new property must be identified within 45 days of the sold property’s closing.
3. The new property must be purchased within 180 days of the sold property’s closing.
4. A qualified intermediary must perform the exchange.
5. Titles must be exactly the same for all exchanged properties (there are some exceptions to this rule in the case of disregarded entities that could be discussed with a qualified intermediary).
6. New properties must be of equal or greater price to original property.
7. Titles cannot be in the same name at the same time.
Considerations Before Executing a 1031 Exchange
Replacement Property Criteria
The 1031 exchange applies only to real estate. It does not cover “exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets” (“Like-Kind Exchanges”). This means that the chosen replacement asset must be of similar type and class in order to be eligible for the exchange.
Determining What Like-Kind Looks Like in a 1031 Exchange
When it comes to determining what like-kind properties are, in this particular case, we are talking about exchanging one multifamily property for another (a single family home for a multifamily property wouldn’t be an eligible exchange). Further to that point, 1031 exchanges are for investment real estate. Personal properties are not covered by the 1031 exchange.
The relinquished and purchased properties must be used for investment, trade, or business. Vacant property is always considered like-kind, whether leased or not leased.
Property that is strictly intended for resale is not qualified for an exchange; properties must be held for investment to be exchanged. However, the like-kind rule is very flexible when determining the properties qualified for a 1031 exchange.
Property Titles
In a 1031 exchange, the property titles must be identical. The taxpayer whose name is listed on the relinquished property must be the same taxpayer that is listed on the purchased property. Similarly, when a trust or corporation is listed on the relinquished property, the same trust or corporation must be listed on title for the purchased property
The Reverse Exchange
In the event of delayed payment from the sale of the relinquished property, the reverse exchange offers a solution for investors. In order to avoid having both properties of the exchange titled in the same name at the same time, the purchased property will go into an exchange accommodation titleholder or EAT, typically an LLC, and the profit and title will be held by the LLC until the first property is relinquished.
The Right Time to 1031
A key factor behind the benefits of a 1031 exchange is timing. The 1031 exchange starts the date the deed is recorded or the date the relinquished property is transferred to the buyer. The 1031 exchange ends 180 days after the exchange begins.
The replacement property must be identified within 45 days of the relinquished property’s closing. The replacement property must be purchased within 180 days of the relinquished property’s closing.
How Deferred Capital Gain Works
In the exchange, capital gains taxes are deferred. The exchange is not 100% tax-free; the taxes are deferred until the sale of the property. If the property owner dies before an actual sale of the property, their children can acquire the property with little to no taxes.
How to Avoid Disallowing a 1031 Exchange
An Intermediary Party Is Required
Many people like to do everything themselves. In the case of a 1031 exchange, this is not possible. A third party is necessary for the exchange to be valid, and taxes to be deferred.
Utilize a Reverse Exchange When Necessary
Holding both the property that is up for sale and the replacement property at the same time will disallow the exchange. The reverse exchange protects against this.
Be Mindful of Boot
Investors that use debt within exchanges may pay off the debt with the sale of the relinquished property and think they’re debt free. However, this debt used in the relinquished property is known as boot: the amount of debt owed from a sale that has to be accounted for. Having boot will incur capital gain taxes.
Financing a 1031 Exchange
Though most taxpayers use cash to fund their exchanges, it is a good idea to use leverage when financing the exchange. Leveraging your exchange offers different benefits than simply using cash.
Regardless of where rates are at, great financing terms afforded by Fannie Mae and Freddie Mac for multifamily financing, investors can buy a lot more property at a much lower cost. That improve cash-on-cash returns and overall appreciation during the investment term.
Using Leverage to Improve Cash on Cash
To improve cash-on-cash returns, investors should partner with a financial intermediary like Multifamily Loans. Though minimum loan amounts generally start around $1 million, exceptions can be made for loans as low as $500,000.
Benefits of Leverage in 1031 Exchanges
Instead of using cash to finance the entire exchange, investors can use leverage to acquire more property for their replacement properties.
For example, if the relinquished property sells for $1M in cash, that $1M can be used as down payment and a loan can be used to finance the purchase of multiple or pricier multifamily properties.
Using leverage, a buyer with $2 million in a 1031 could buy a $2 million multifamily property, a $4 million property (with a 50% loan), or a $10 million property (with an 80% loan).
If the original property were leveraged, the new property must assume an equal or greater amount of debt. As long as the capital gains debt from the original property is superseded, the investor can take out more leverage to purchase more property.
Additionally, investors looking to finance the additional costs of their replacement property may find partners willing to furnish some or all of the money. Certain sellers may also be willing to finance their own property’s purchase price to assist with the closing costs or simply to provide some additional leverage.
Replacing Debt in a 1031 Exchange
Due to the fact that any proceeds earned from the sale of the first property must be used entirely for the replacement property, questions may arise concerning leverage. Where leverage is involved, it is important to replace the debt to avoid a boot that will disallow your exchange.
For example, if your property sells for $2 million, the escrow company collects $2 million from the buyer and pays off your original loan of $1 million. The escrow company sends the intermediary the $1 million in equity that the taxpayer must then use when purchasing the replacement property.
However, because this is an exchange, the debt from the loan is considered a capital gain. Thus, the taxpayer must purchase the new property with the $1 million in equity and $1 million in new debt. This way, all capital gain has been used to purchase the new property.
Crowdfunding for Multifamily and Commercial Real Estate
Crowdfunding has gained much popularity in the past few years as an alternative to financing real estate investments. With crowdfunding, multiple investors pool their capital and can use that to either finance real estate investments for other investors and earn a fixed yield, or even a percentage of profits. Investors can also use crowdfunding to create the equity required and buy an investment property together.
Some crowdfunding companies have established platforms to invest money that qualifies for a 1031 exchange, in that if you have sold a property for a 1031 exchange, you can invest in a crowdfunded investment instead of an entire property on your own. This would allow an investor to invest in pieces of several properties simultaneously, or one large property with other investors. This is done using a Delaware Statutory Trust.
The Delaware Statutory Trust
There are a special class of properties that can be used as replacement multifamily properties that are structured as securities in a Delaware Statutory Trust. Investors purchase interests in the trust, which holds property titles and guarantees the mortgage loan.
The DST allows for investors to purchase into more expensive properties that they may not have been able to afford by themselves, sometimes via crowdfunding for commercial real estate platforms. These DST properties may include retail buildings, shopping centers, office buildings, and apartment complexes that are typically valued in the $5 to $50 million price range.
Leveraged 1031 Exchanges for Apartments
In summary, it is safe to say that it is a great investment opportunity to leverage the rights afforded by the 1031 exchange, specifically when investing in multifamily property. The government is giving investors the rights to invest its own money at no additional cost to the investor.
Furthermore, with treasury yields as low as they are, there’s an added benefit to using leverage in order to purchase more property at a very reasonable cost. Now is a great time to use a 1031 exchange to invest in a new property, or portfolio of properties using a bit of leverage in order to bolster both short and long-term returns.
Related Questions
What is a 1031 Exchange?
A 1031 exchange — named after section 1031 of the U.S. Internal Revenue Code, which provides the tax deferral treatment for qualifying exchanges — is a type of commercial real estate transaction that allows an investor to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds from the sale into the acquisition of a similar property, making the 1031 exchange a powerful tool for savvy investors.
Besides simply saving on the tax bill, investors should consider the use of a 1031 exchange as a viable exit strategy when there are other investment opportunities on the table. The strategy not only provides the perfect way to offload a property without paying taxes on the sale, but also to grow an investment portfolio in the process. Since the rules of the exchange dictate that the replacement property must be of greater or equal value, investors have the opportunity to actually trade up when exchanging properties — utilizing more of the capital from the sale of their asset for the new investment than they would have been able to after a typical sale.
For more information, please visit An Investor’s Guide to the 1031 Exchange.
What are the benefits of a 1031 Exchange?
The 1031 Exchange offers several benefits, including deferral of capital gains taxes and depreciation recapture, no limit on the number of exchanges an investor can make, and the ability to exchange for a property of greater value, increasing the value of an investment portfolio.
Besides saving on the tax bill, investors should consider the use of a 1031 exchange as a viable exit strategy when there are other investment opportunities on the table. The strategy not only provides the perfect way to offload a property without paying taxes on the sale, but also to grow an investment portfolio in the process. Since the rules of the exchange dictate that the replacement property must be of greater or equal value, investors have the opportunity to actually trade up when exchanging properties — utilizing more of the capital from the sale of their asset for the new investment than they would have been able to after a typical sale.
For more information, please visit An Investor’s Guide to the 1031 Exchange.
What are the requirements for a 1031 Exchange?
A 1031 exchange allows a property owner to offload an investment property and use the equity from that sale to purchase a new, similar property, deferring 100% of capital gains taxes in the process. In order to execute a 1031 exchange, there are a few guidelines that must be followed. For starters, the asset that will be exchanged must have been held solely for business or investment purposes. Next, the property that will be acquired must be like-kind — meaning it must be of a similar use or nature to the property being exchanged (i.e. exchanging a vacant lot for a vacant lot, or a rental property for a rental property). Additionally, the target property must be of equal or greater value to the original asset. Finally, 1031 exchanges must be completed within a certain time frame. An investor is typically given a period of 45 days from the sale of the first property in which they must identify the replacement property for the exchange. Furthermore, the actual acquisition of the replacement property must be closed within 180 days of the sale. It is important to note that the actual exchange must be performed by a qualified intermediary. There are strict title requirements that must be adhered to – most notably that both titles cannot be in the same name at the same time.
Sources: An Investor’s Guide to the 1031 Exchange and Understanding Capital Gains Tax
What are the risks associated with a 1031 Exchange?
The risks associated with a 1031 Exchange include the possibility of the investor not finding a suitable replacement property within the required time frame, the investor having to pay capital gains taxes on the deferred gain if the investment property has appreciated significantly in value, and the complexity of the process which requires a qualified intermediary to execute.
For more information, please see An Investor’s Guide to the 1031 Exchange.
What are the tax implications of a 1031 Exchange?
A 1031 Exchange allows an investor to defer their capital gains tax bill by “exchanging” their current property with a similar commercial property. The new property must cost at least as much as the original one, and personal residences are not eligible. Investors are not required to already have a new property lined up immediately for the exchange to take place; instead, they can utilize something called a reverse 1031 exchange. This allows a delay in purchasing the exchange property for a period of 180 days (additional time may be allowed in some scenarios). The 1031 exchange also generally allows borrowers to delay paying depreciation recapture taxes, though they will still be required to pay them at some point.
Besides simply saving on the tax bill, investors should consider the use of a 1031 exchange as a viable exit strategy when there are other investment opportunities on the table. The strategy not only provides the perfect way to offload a property without paying taxes on the sale, but also to grow an investment portfolio in the process. Since the rules of the exchange dictate that the replacement property must be of greater or equal value, investors have the opportunity to actually trade up when exchanging properties — utilizing more of the capital from the sale of their asset for the new investment than they would have been able to after a typical sale.
For more information, please visit Understanding Capital Gains Tax and An Investor’s Guide to the 1031 Exchange.
What are the best strategies for a 1031 Exchange?
The 1031 Exchange is a great strategy for investors looking to offload a property without paying taxes on the sale, while also growing their investment portfolio. The rules of the exchange dictate that the replacement property must be of greater or equal value, allowing investors to trade up when exchanging properties.
The main benefit of this strategy is that it allows you to defer paying capital gains taxes on the sale of your property. The downside is that you have to find another investment property of equal or greater value within a certain timeframe, which can be difficult depending on market conditions.
For more information on the 1031 Exchange, check out The Everything Guide to the 1031 Exchange for Apartments and Using Leverage to Bolster Returns.
- Understanding 1031 Exchanges
- 1031 Exchanges and the Depreciation/Appreciation of Multifamily Properties
- How to Perform a 1031 Exchange
- Considerations Before Executing a 1031 Exchange
- Replacement Property Criteria
- Determining What Like-Kind Looks Like in a 1031 Exchange
- Property Titles
- The Reverse Exchange
- The Right Time to 1031
- How Deferred Capital Gain Works
- How to Avoid Disallowing a 1031 Exchange
- An Intermediary Party Is Required
- Utilize a Reverse Exchange When Necessary
- Be Mindful of Boot
- Financing a 1031 Exchange
- Using Leverage to Improve Cash on Cash
- Benefits of Leverage in 1031 Exchanges
- Replacing Debt in a 1031 Exchange
- Crowdfunding for Multifamily and Commercial Real Estate
- The Delaware Statutory Trust
- Leveraged 1031 Exchanges for Apartments
- Related Questions
- Get Financing