Every taxpayer’s situation is unique and therefore every 1031 exchange is individually nuanced. Despite the innate differences in every potential exchange, a pattern has emerged as to the most common reasons that an individual will move forward and utilize a 1031 exchange. Below are the top ten reasons we’ve found that have motivated taxpayers to move forward.
1. Defer capital gains.
Plain and simple. If your specific tax situation has you owing federal and or state capital gains of any kind, a 1031 exchange will allow you to defer all gains incurred. Additionally, it will allow you to defer the twenty-five percent depreciation recapture tax.
2. Appreciation.
The property may have appreciated in value to the degree that it only makes sense to capture the value and replace with another asset to allow that asset to continue to appreciate. Consider this as an investment strategy when you’ve maximized your perceived potential in the property you currently own.
3. Depreciation.
The property may have been held for twenty or more years. There are few years left to take additional depreciation. A 1031 exchange allows the Exchangor to replace with another property that resets the depreciation schedule, allowing for additional depreciation to be taken.
4. Cash flow.
Utilizing a 1031 exchange into a residential, commercial property or tenants in common allows for a cash flow when the existing property does not. Consider also the opportunity to trade out of a single family home into a duplex, quadplex or apartment building. This strategy could provide multiple streams of income.
5. Consolidation.
Instead of holding multiple properties, consolidate into one. Reduce the labor intensity of managing multiple properties and focus on one. If you own multiple residential properties, consider consolidating into a single apartment complex.
6. Diversification.
If one type of property is held, sell the individual property and replace with multiple diverse property types. In a 1031 exchange, you are able to exchange real property with other “like kind” real property used for trade, business or investment. Perhaps you have a highly appreciated plot of farm land and would prefer to diversify into a warehouse space, a duplex and a plot of undeveloped land. As long as the properties in this case show a fact pattern of being held for investment, you are eligible for an exchange.
7. Relocation of investment.
Sometimes the taxpayer moves and wants to be close to the investment property either for limited personal use or to manage. This also applies if the taxpayer would prefer to move their investments out of a region that is underperforming into a more desirable market. There is no restriction in regard to exchanging like kind property in the United States with the exclusion of Puerto Rico and additional qualifications for the U.S. Virgin Islands.
8. Build on land already owned.
In this scenario, either the Exchangor owns land or a building that can be improved with the exchange proceeds and debt retired. This is often the case in commercial real estate where the taxpayer owns multiple properties, one of them being land.
9. Makes economic sense to sell.
The current property is within the path of progress. An offer has been tendered; it makes sense to sell and relocate. If a government entity is buying the property or forcing the sale, the sale may be eligible for a Section 1033 or condemnation. This type of transaction allows the capital gain tax to be deferred with up to two years to replace.
10. Estate planning.
With the assistance of an estate planning attorney or professional, in preparation for the next line of owners or if the current ownership wants to part company, a 1031 exchange is a viable strategy.
As with any exchange, we recommend that the taxpayer review their individual tax situation with their CPA to ensure that a 1031 exchange is the right option. The most common reason to utilize a 1031 exchange is simply to defer the capital gain and depreciation recapture in order to reinvest the retired debt—if any—and net proceeds. Hundreds of thousands of exchanges are initiated each year by individuals, trusts, LLCs and corporate entities deferring the gain and utilizing the proceeds interest free towards the replacement property purchase. Consider any of these ten reasons and deploy this valuable strategy towards building long term wealth.
