A 1031 exchange is a common way for real estate investors to defer capital gains taxes on the sale of an investment property. But this provision isn’t just for professional investors. It can provide powerful benefits to any owner of appreciated real estate, including potential tax-deferred growth, more straightforward estate planning and the ability to “exchange up” into higher-value properties. With these benefits, however, comes the responsibility of managing assets. One turnkey solution, a Delaware Statutory Trust, can provide those benefits within a passive ownership structure.
How 1031 Exchanges Work for Investors
A 1031 exchange, or Starker exchange, is named after Section 1031 of the U.S. Internal Revenue Code. It allows investors to defer capital gains taxes on the sale of investment property if the asset being sold is exchanged for “like-kind” property within a certain time frame. The “like-kind” nature of the properties simply means that the asset must be real property, held for productive use in a trade or business, or an investment property. The investor cannot use a primary residence, vacation home or interest in a real estate fund in a 1031 exchange. However, the properties being exchanged don’t have to be in the same asset class. For example, an investor can sell vacant land and exchange the proceeds for an apartment building. We offer investors access to Origin Exchange, our 1031 exchange program.
Property Types Eligible for a 1031 Exchange
1031 Exchange Vs. Qualified Opportunity Zone Funds
Qualified Opportunity Zones (QOZs) were implemented as part of the Tax Cuts and Jobs Act of 2017. QOZ funds allow investors to defer and eliminate capital gains taxes from any source, not just real estate. If an investor realizes gains from the sale of a business, stocks or private property, they could invest it in a QOZ fund. If they are selling real estate, their options expand to include a 1031 exchange or QOZ fund. Origin offers both strategies, including our QOZ Fund III, and we can help investors weigh the benefits and characteristics of both options.
Key Rules Around 1031 Exchanges
As with any tax-based strategy, the requirements are complex, so it is important for investors to complete the 1031 exchange with experienced advisors (learn more about Origin Exchange’s process here). There are a few key rules to understand before selling investment property.
Qualified intermediary: An investor can never take constructive receipt of proceeds from the sale of a relinquished property. Therefore, an escrow agent, known as a qualified intermediary, or QI, must be set up beforehand to take possession of proceeds at closing. Because the QI is an important part of the process, we strongly recommend working with an experienced QI who has facilitated many 1031 transactions.
Time frame: Upon closing of the relinquished property, the clock begins ticking for the 1031 investor.
- 45 days: The investor must identify a replacement property within 45 days of closing.
- 180 days: The investor must close on the replacement property within 180 days of closing on the relinquished property.
1031 Exchange Timeline
Matching value: When completing an exchange, the investor must replace the relinquished property with a property of equal or greater value. Is there outstanding debt on the property being sold? That debt must be replaced on the new property or cash must be added to the exchange to equal the amount of debt.
What are the Benefits of a 1031 Exchange?
The benefits to a 1031 exchange are myriad. Here are two key ones investors will receive:
Tax deferral: There are many taxes on the sale of appreciated real estate. Those include federal capital gains, state income tax, depreciation recapture tax and potentially net investment income tax (NIIT). So with a properly structured exchange, all these taxes are deferred, and the basis from the original property is rolled over. There are no limits on how many times an investor may complete a 1031 exchange. This encourages continuous property reinvestment. It also allows the investor to “exchange up” into higher-value properties for the rest of their lifetime.
This tax-deferred growth can be a powerful wealth-generating tool. Over time, without frictional and tax expenses, investors have the potential to substantially increase the value of their portfolios. To compare possible tax savings on a specific property by employing a 1031 exchange, use our tax calculator.
Estate planning: There is no limit on the number of 1031 transactions an investor can complete. So investors can exchange up to new properties and “swap until they drop.” When the investor passes away, the property can be passed on to beneficiaries with a fully stepped-up cost basis.
Delaware Statutory Trusts: Passive Ownership
Every real estate owner has unique circumstances. And most who have accumulated assets during their lifetime want to transition into passive ownership. That means spending their free time on things they truly enjoy instead of the “three Ts” of active real estate management—toilets, tenants and trash, as the saying goes. In these cases, employing a Delaware Statutory Trust (DST) structure allows 1031 exchange investors to exchange their proceeds for an interest in a professionally managed asset and receive passive income.
Learn More
While a 1031 exchange can provide many advantages, it’s also important to understand the rules. Each investor’s situation and investing goals are unique. So, independent research and finding expert guidance ensures legal compliance and the chance to receive the maximum benefits. Find out more about DSTs and how Origin Exchange can help you participate in these unique investments.
