What Is a 1031 Exchange?

When you sell an investment property, you have to pay capital gains taxes at the time of the sale. The exact amount depends on your income bracket and whether it is a short- or long-term gain. Generally speaking, you will be federally taxed at about 15-20% on any long term capital gains. 

If you sell your property and execute a 1031 exchange (also called a like-kind exchange) instead of an outright sale, you can defer the capital gains taxes by reinvesting the proceeds from the sale of your investment property into a new property or group of properties worth an equal or greater value. 

If you sell off your investment properties you will have to pay the capital gains taxes at that time and usually pay the taxes off on a low basis, tracing back to your first purchase before the 1031. As of now (2022), you can eliminate the gains taxes forever by leaving the properties to your heirs. Your heirs can inherit the assets at a stepped up basis, which means the property values would be assessed at the time of your heirs taking ownership.

There is no limit to the number of 1031 exchanges you can do, as long as you hold onto your properties for long enough, typically two years at the minimum. Keep in mind, you need to hire a Qualified Intermediary (QI) to facilitate each of your 1031 exchanges. 

Advantages of a 1031 Exchange

With a 1031 exchange, you can trade up for a property or multiple properties without paying the taxes on the equity to purchase the new investment. This means  higher-value properties are more accessible while earning on capital gains that would have normally been paid to the government. Having no limit to the number of 1031 exchanges you can perform, in theory, you can build up massive equity over time.

Disadvantages of a 1031 Exchange

While many people (mostly brokers) only speak of the advantages of 1031’s, there are disadvantages that in many cases overshadow the advantages. On paper, the benefits of 1031 exchanges can be huge, but in reality, there are a few key disadvantages to be aware of before you start exchanging.

The first is the condition of the real estate market. While a market is high or low, you are still selling and purchasing in the same market: “Sell high, buy high.”

The second is you may be forced into an overvalued asset. There is a tight timeline. You have 45 days from the sale of your relinquished property to identify a new 1031 property or group of properties you plan to purchase in the exchange. If you are familiar with investment real estate, that is not a lot of time to find a quality replacement asset. If you have a low basis and are facing a large tax consequence, you are pressured to identify assets that may be overpriced. On a broad overview, this can impact markets by driving comparison sales and appraisals upward and add to other contributing factors of compressed lower returns on investment properties.  

Another Option to the 1031

There are not many alternatives to the 1031 exchange, but one procedure that solves the issue of deferring capital gains while not being totally at the mercy of the current market conditions and confined timeframes is the 721 exchange. 

Our Dual City Advantage Fund is offering investors an alternative to the limited 1031 cycle. In exchange for contributing property to the DC Advantage fund, owners are given ownership units of the overall fund equal to the equity value of that asset. These units have a cash value and return dividends while being held. Units also offer a distinct advantage to owners who wish to go to cash and tax plan over time, or they can hold and enjoy passive cash flow in a diversified fund while leaving their heirs the units at a stepped up basis similar to that of the 1031.