Editor’s Note: Haute Lawyer Roxana Tejeda talks about the pros and cons of a 1031 exchange, in which properties are traded without capital gains taxes being imposed on them.
Photo Credit: Courtesy of Tejeda Law Group
For anyone not in the field, it’s easy to feel overwhelmed when taking a look into the world of real estate law. “Ad-valorem”, “APR” and other terms often leave first-time business or property owners puzzled. Even the most advanced real estate investors, too, get tangled in one, universal topic—taxes. Property taxes can be explained with the right legal counsel. However, those who own multiple properties should already be familiar with a 1031 exchange—a trade of properties without capital gains tax (used on the sale and profit of a property). As a real estate attorney, I see people struggle to look at a 1031 exchange with both the benefits and setbacks.
Pros:
- Quit plainly, a 1031 helps you defer taxes and get better, more efficient properties. Essentially, you are “trading up” and turning a profit. Earnings made can be used to further investments, update properties, and expand a business.
- Not only does a 1031 defer taxes, it can also help defer “depreciation recapture.” This occurs when the property owner is taxed (up to 25%) on the depreciation of an asset once it’s sold. So long as an equal or great amount is reinvested in the exchange, a 1031 can help with a total deferral.
- When it comes to estate planning, 1031 exchanges can be used until the time of the property owner’s death. When the property is passed down, and if the property does not increase in value, taxes may also be deferred with the beneficiary.
Cons:
- Investors should know a 1031 is only applicable to “like-kind” property. These are businesses held for investment only (not personal use). For example, a retail shopping center could be exchanged with a secondary retail center. It cannot; however, be exchanged with something like a vacation home. They must be held for the purpose of business or investment.
- A 1031 might require a high investment, meaning it’s an exchange done by those who already have the capital. You also must be able to afford a qualified intermediary—a neutral party, which excludes an attorney, certified public accountant, or family member—who helps with the transaction of the property. QI fees range from “$600 to $1200 with certain incidental expenses” (Frankel).
- Within an LLC or partnership, a company must do a 1031 exchange as an entity. All partners involved must commit to the exchange and the purchase of the property. However, the “drop and swap” approach allows certain partners be considered a tenancy in common (TIC) which avoids taxes. What complicates this situation; however, is that some aspects of “how?” are not specified in the IRS code—leaving one or more partners confused on the legality of dissolving one or more partners in the LLC.
However you look at the 1031 exchange, it’s best to consider all possible outcomes. Risk is the number one factor in any real estate investment. Knowing when to take one or not requires the right planning, education, and foresight. As an attorney, I help property owners weigh those risks without missing out on potential benefits. For some, a 1031 exchange is the farthest from simple but worth the time and effort to look at—and from all angles.
For more on Roxana Tejeda, visit her Haute Lawyer profile at https://hauteliving.com/hautelawyer/member/roxana-tejeda/
Sources:
“How Much Does a 1031 Exchange Cost” Matt Frankel, Million Acres.
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