Real estate investors who liquidate their properties often turn to a 1031 Exchange so they can reinvest the proceeds without paying capital gains taxes. While this may be the right strategy for some investors, it isn't always the right strategy for you. Below are reasons why a 1031 Exchange may not be the ideal choice - and what you should do instead.
Here are five reasons why a 1031 Exchange may not be right for your situation:
- You want to invest in something different. The 1031 Exchange rules require that you reinvest the sale proceeds into a "like-kind" asset. If you're selling real estate and want to invest in stocks, bonds, or collectibles, your transaction would not qualify. while this may not be a better opportunity to grow your wealth tax efficiently, it would allow you to invest your POST tax dollars in any way you see fit.
- A 1031 Exchange provider adds another layer of expenses. This strategy requires that a third-party intermediary complete the process. While the fees tend to be less than $1,500, this added expense eats into your profits. Which comes into play on smaller exchanges.
- You do not have access to your money during a 1031 Exchange. For the 1031 Exchange to qualify for tax deferral, you cannot receive the funds. They must go through the intermediary and be held there until your transaction is complete. You cannot take advantage of other opportunities in the meantime.
- The 45-day window to identify a new property is too short for you. To qualify for a 1031 Exchange, you must identify your replacement properties within 45 days of the close of your sale. This short timeframe can lead investors to rush the decision-making process and cause them to settle for a less-than-desirable property just to avoid capital gains taxes.
- Replacement transactions must close within 180 days. You have 180 days from the date of your sale to close on the purchase of a replacement property. Almost six months seems like a long time, but some deals can drag on longer due to appraisal, environmental, or other concerns. If you do not close before the 180-day window expires, you lose out on the tax benefits.
If you've decided that a 1031 Exchange is not right for you, here are a few alternatives to consider also offer tax benefits:
- Qualified Opportunity Zone. When you sell appreciated property and invest the GAIN into a QOF, capital gains are deferred until December 2026. At this time, you'll receive a 10% reduction in capital gains taxes owed. Additionally, if you hold the new asset for at least 10 years, no new capital gains taxes are owed.
- Installment Sale 453. When you sell your property through an installment sale, it spreads the tax liability over the course of multiple years. This approach could keep large chunks of your gains in lower tax brackets and avoid or reduce the 3.8% Net Investment Income tax.
- Charitable Remainder Trust. This strategy can be ideal for investors who wish to leave some of their estate(s) to charity. You'll transfer your property into the trust, which then sells the asset to avoid paying capital gains taxes. The trust pays you a lifetime income, then donates the remainder when you pass away.
The Bottom Line
Don't let the fear of a capital gains tax bill rush you into buying another property quickly through a 1031 Exchange. Although 1031 is often the best choice for real estate investors, other investing strategies can be effective at delaying or eliminating capital gains taxes as well. Contact us today to discuss and weigh out the pros and cons of the many options available for your unique situation. You can also schedule some time on our calendars here.
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This is for informational purposes only, does not constitute as individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.
There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to sell any securities.
DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney.
Diversification does not guarantee profits or guarantee protection against losses. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This information is not meant to be interpreted as tax or legal advice. Please speak with your legal and tax advisors for guidance regarding your particular situation.
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