Unfortunately, we may have a much better reason in a few months to do a 1031 exchange when and if the Bush tax cuts expire. However, there will likely be folks who decide to cash out and sell before the new rates take effect. Frankly, that make a bunch of sense if the new rates are going to be at or near the earned income rate.
However, for the purposes of this post, which is the third in my miniseries on 1031 exchanges, let’s look at the five primary reasons for doing a 1031 exchange.
Preservation of equity
A properly structured and executed 1031 exchange provides the investor with the opportunity to defer 100% of federal and state capital gains taxes. This, for all practical purposes, provides the investor an interest free no term loan on taxes due until the property is sold. Capital gains taxes can be delayed indefinitely by exchanging from one property to the next thereby greatly increasing the value of their investments over time.
Many investors 1031 exchange from a property that is free and clear into a more valuable property using some leverage. A larger property provides more cash flow plus a greater depreciation write-off, which increases the return on investment. This of course depends on market interest rates being lower than market caps rates. If market caps are 6% and the market interest rate is 7% then this isn’t going to much help.
Conversely, if an investor owns a property free and clear in a 4 ½ cap market and sells, does a 1031 exchange, and invests in one or more (200% rule applies) properties at a 6% cap with 50% leverage, there can be a huge increase in after tax cash flow.
1031 exchanges allow an investor to diversify to other geographic regions or to other products types. If an investor owns in a cyclical market such as LA with huge swings up and down, it would be possible to diversify some of those holding into markets such as the plain states or certain cities in the Midwest where average appreciation is lower, but a far more linear market plus the cap rate is a couple of points higher.
Another possibility is exchanging from high maintenance PITA multifamily residential into absolute net retail where there are properties with no landlord responsibilities. .
This one ties in the above a bit. Maybe you as an investor have accumulated a large portfolio of multifamily residential properties over the years and you’re not quite as young as you were 15 or 20 years ago so you might be looking for a way to reduce the multifamily residential headaches by doing a 1031 exchange on some of your properties into absolute net or triple net retail or even net leased distribution or warehouse.
I’ve had several calls just like this recently. Sometimes a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property, which they can either hold or sell.