Many property managers who invest in real estate have come to realize the numerous benefits it offers. However, certain circ*mstances, like shifting investment goals, property upgrades, or a need to limit liability may prompt them to sell their property. Regardless of the reason, this decision is often accompanied by the daunting realization they have to pay capital gains taxes. This amount can range anywhere from 15-20% of the sale price, with an additional surtax of up to 3.8% some states impose on higher-income earners.
Fortunately, more and more property managers are taking advantage of a 1031 exchange, which allows them to defer capital gains taxes on the sale. While a 1031 exchange might seem like an ideal choice, there are some other options that may be worth considering.
In this article, I will simplify and present to you the available alternatives to 1031 exchanges, with the hope that it provides you with the necessary information to make an informed decision about the best option for your investment needs.
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What Is a 1031 Exchange?
Perhaps you are already aware of how 1031 exchanges work — if so, feel free to skip ahead using the bookmarked links above. For those yet uninitiated or less familiar, 1031 exchanges (tax-deferred exchanges) are outlined by Section 1031 of the Internal Revenue Code (IRC) as a transaction that allows investors to defer paying capital gains taxes on the sale of investment property by reinvesting the proceeds of the sale into another “like-kind” property. This means that 1031 exchanges cannot typically be done on other property types such as primary or secondary properties.
A “like-kind property” refers to real estate of equal or greater value that is also used for investment purposes. In essence, with a 1031 exchange, the investor can exchange one property for another without incurring immediate tax liability.
A few of the benefits of executing a 1031 exchange include:
Saving money by deferring capital gains taxes.
Diversifying your portfolio with new and/or more properties.
Potentially improving cash flow with rental income from more profitable properties.
Investors must adhere to a specific set of rules for a successful 1031 exchange, which includes completing the exchange within very specific timeframes. For instance, a replacement property must be identified within 45 days of the sale of the original property and the entire exchange must be completed within 180 days. These two windows occur concurrently.
Because some state-specific incentives may align with your investment objectives, it’s also worth noting that 1031 exchanges allow you to exchange property from one state to another. So, while 1031 exchanges can be incredibly beneficial when you decide to sell an investment property, the IRS has set stringent guidelines that must be followed down to a T.
Alternatives to 1031 Exchanges
While a 1031 exchange is a popular option for deferring capital gains on the sale of real estate, it’s not the only option available. Here are a few alternatives to 1031 exchanges to consider:
Opportunity Zones. Opportunity Zones are designated as economically distressed areas in which investors can receive tax benefits for real estate investments. By investing in these areas, investors can potentially defer or eliminate capital gains taxes on their profits.
Delaware Statutory Trusts (DSTs). A DST is a type of trust that allows multiple investors to pool their funds and invest in a larger commercial property. This strategy can provide investors access to properties they might not be able to afford on their own, while also offering potential tax benefits.
Installment Sales. An installment sale is when a property owner uses multiple payments over time to sell their property, rather than one lump sum. This can help spread the tax burden over a longer period, potentially reducing the overall amount of taxes due from the owner.
Paying Capital Gains Taxes. While it may not be the most attractive option, simply paying capital gains taxes on the sale of a property remains a viable alternative. This may be a good option for investors who want to cash out of their investment entirely and move on to other opportunities.
721 Exchanges. In a 721 exchange, the owner contributes their property to a partnership with a Real Estate Investment Trust (REIT), and in return, receives operating partnership units (OP units) in the REIT. These OP units can be exchanged for REIT shares at a later time, allowing the property owner to defer capital gains taxes until they are sold.
| Comparing Alternatives to 1031 Exchanges | ||
| Investment Option | Pros | Cons |
| Opportunity Zones | Supports redevelopment of blighted areas; offers tax benefits and potential for higher returns. | High-risk investments may not see significant growth or appreciation. Investors must follow strict guidelines. |
| Delaware Statutory Trusts (DSTs) | Offers access to larger commercial properties with potential tax benefits. | No control over property management decisions; limited flexibility for reinvestment options. |
| Installment Sales | Can spread tax burden over a longer period, which could also reduce overall amount of taxes. | The need to sell in multiple payments may limit investment opportunities. |
| Paying Capital Gains Taxes | Cash out your investment and move on to other properties without further obligation. | Without tax deferral or reduction options, investors may face a weighty tax burden or large out-of-pocket expenses. |
| 1031 Exchanges | Defer taxes on real estate sales to invest in other properties. Untethers the investor from the property and allows them to enhance their portfolio. | Strict guidelines for reinvestment; potential for delayed closings or increased costs if guidelines are not closely followed. |
| 721 Exchanges | Allows investors to exchange shares in a REIT without incurring capital gains taxes. | Extremely limited options for REIT investments. Potential risks: changing interest rates, economic downturns, and volatile real estate markets. |
It’s impossible to overemphasize the distinctive nature of each transaction, which parallels the individual concerns of every investor in terms of goals, risk tolerance, and time constraints. Although 1031 exchanges are an excellent tool for tax deferral, they aren’t the only option at your disposal when you decide to sell an investment property.
If you’re trying to determine whether a 1031 exchange or one of these various alternatives is the best choice for you, it’s critical to consult with an experienced professional. They can help narrow down the investment options that align with your goals, and take your individual circ*mstances and objectives into account. Don’t make a hasty decision and risk missing the best opportunities – seek advice from the experienced team at Canyon View Capital.
Canyon View Capital Makes Real Estate Investing Make Sense
At Canyon View Capital, we understand that while a 1031 exchange can be a great tool for deferring taxes, it’s important to explore all options available to you, including some alternatives to 1031 exchanges. Our team has over four decades of experience managing real estate that has amassed over $1B1 in aggregated value. We’re eager to share our expertise and help you explore the world of real estate investing.
For all the benefits a 1031 exchange can offer, it also comes with a narrow window for execution and specific requirements that can be difficult to meet, even for experienced investors. At CVC, we can help you understand the process and accommodate your needs accurately and swiftly.
Our commitment to our investors goes beyond just helping with a 1031 exchange. We’re dedicated to guiding you through the entire process and ensuring that you have a thorough understanding of all your options. At CVC, we want to help you make the best investment decisions possible, and we have the experience and expertise to do just that.
