Understanding 1031 Exchanges
Understanding the ins and outs of the 1031 exchange is a huge benefit to apartment investors. In the most simplified of explanations, a 1031 exchange allows a property owner to offload an asset and use the equity to purchase new property, with 100% of capital gains taxes deferred. Essentially, in deferring capital gains tax obligations, investors are able to use the government’s due tax dollars for real estate investment and earn the return on that capital without having to pay anything to the government besides the actual tax obligation owed whenever, in the future, the investor chooses not to exercise their right to a 1031 exchange.
The key benefit of the 1031 exchange — and what makes it different from the standard sale of an asset — is found in the fact that the transaction is an exchange and NOT a sale. The exchange of one property for another allows for the taxpayer to avoid the tax of the “sale”, and qualify for deferred capital gain treatment. Simply selling an asset reduces an investor’s buying power — asset sales can be taxed beyond 20% or even 30%, based on federal and state tax rates. These taxes essentially make it so that the total profit of the sale of a property could be reduced to 70% - 80% of its original worth.
1031 Exchanges and the Depreciation/Appreciation of Multifamily Properties
The 1031 exchange is perfect for investors with multifamily properties that have either appreciated or depreciated significantly.
If your multifamily building has depreciated significantly to the point of being ineligible for annual depreciation deductions on tax returns, your multifamily property’s annual returns have depreciated as well, indicating a need for a change in property so as to maximize investment dollars.
In the case of appreciation, if the apartment property itself has reached, or is close to reaching maximum appreciation, it may prove more beneficial to exchange for a new property that has greater upside potential. This strategy is particularly useful in a low interest rate environment, wherein the investor can exchange the asset for more property, with increased income and potential long-term appreciation at a lower cost than historically normal (due to the low interest rate environment).
How to Perform a 1031 Exchange
When determining how to perform a 1031 exchange, there are specific guidelines the IRC Code puts forth.
A successful 1031 exchange will require seven things:
1. The properties up for exchange must be like-kind (i.e. an apartment building for an apartment building).
2. The new property must be identified within 45 days of the sold property’s closing.
3. The new property must be purchased within 180 days of the sold property’s closing.
4. A qualified intermediary must perform the exchange.
5. Titles must be exactly the same for all exchanged properties (there are some exceptions to this rule in the case of disregarded entities that could be discussed with a qualified intermediary).
6. New properties must be of equal or greater price to original property.
7. Titles cannot be in the same name at the same time.
Considerations Before Executing a 1031 Exchange
Replacement Property Criteria
The 1031 exchange applies only to real estate. It does not cover “exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets” (“Like-Kind Exchanges”). This means that the chosen replacement asset must be of similar type and class in order to be eligible for the exchange.
Determining What Like-Kind Looks Like in a 1031 Exchange:
When it comes to determining what like-kind properties are, in this particular case, we are talking about exchanging one multifamily property for another (a single family home for a multifamily property wouldn’t be an eligible exchange). Further to that point, 1031 exchanges are for investment real estate. Personal properties are not covered by the 1031 exchange.
The relinquished and purchased properties must be used for investment, trade, or business. Vacant property is always considered like-kind, whether leased or not leased.
Property that is strictly intended for resale is not qualified for an exchange; properties must be held for investment to be exchanged. However, the like-kind rule is very flexible when determining the properties qualified for a 1031 exchange.
In a 1031 exchange, the property titles must be identical. The taxpayer whose name is listed on the relinquished property must be the same taxpayer that is listed on the purchased property. Similarly, when a trust or corporation is listed on the relinquished property, the same trust or corporation must be listed on title for the purchased property.
The Reverse Exchange
In the event of delayed payment from the sale of the relinquished property, the reverse exchange offers a solution for investors. In order to avoid having both properties of the exchange titled in the same name at the same time, the purchased property will go into an exchange accommodation titleholder or EAT, typically an LLC, and the profit and title will be held by the LLC until the first property is relinquished.
The Right Time to 1031
A key factor behind the benefits of a 1031 exchange is timing. The 1031 exchange starts the date the deed is recorded or the date the relinquished property is transferred to the buyer. The 1031 exchange ends 180 days after the exchange begins.
The replacement property must be identified within 45 days of the relinquished property’s closing. The replacement property must be purchased within 180 days of the relinquished property’s closing.
How Deferred Capital Gain Works
In the exchange, capital gains taxes are deferred. The exchange is not 100% tax-free; the taxes are deferred until the sale of the property. If the property owner dies before an actual sale of the property, their children can acquire the property with little to no taxes.
How to Avoid Disallowing a 1031 Exchange
An Intermediary Party is Required
Many people like to do everything themselves. In the case of a 1031 exchange, this is not possible. A third party is necessary for the exchange to be valid, and taxes to be deferred.
Utilize a Reverse Exchange When Necessary
Holding both the property that is up for sale and the replacement property at the same time will disallow the exchange. The reverse exchange protects against this.
Be Mindful of Boot
Investors that use debt within exchanges may pay off the debt with the sale of the relinquished property and think they’re debt free. However, this debt used in the relinquished property is known as boot: the amount of debt owed from a sale that has to be accounted for. Having boot will incur capital gain taxes.
Financing a 1031 Exchange
Though most taxpayers use cash to fund their exchanges, it is a good idea to use leverage when financing the exchange. Leveraging your exchange offers different benefits than simply using cash. With today’s low interest rates and great financing terms afforded by the likes of Fannie Mae® and Freddie Mac® for multifamily financing, investors can buy a lot more property and a much lower cost and thereby improve cash-on-cash returns and overall appreciation during the term of the investment.
Using Leverage to Improve Cash on Cash
To improve cash on cash returns, investors should partner with a financial intermediary like Multifamily.loans. Though minimum loan amounts generally start around $1MM, exceptions can be made for loans as low as 500K.
Benefits of Leverage in 1031 Exchanges
Instead of using cash to finance the entire exchange, investors can use leverage to acquire more property for their replacement properties.
For example, if the relinquished property sells for $1M in cash, that $1M can be used as down payment and a loan can be used to finance the purchase of multiple or pricier multifamily properties.
Using leverage, a buyer with $2MM in a 1031 could buy a $2MM multifamily property, a $4MM property (with a 50% loan), or a $10MM property (with an 80% loan).
If the original property was leveraged, the new property must assume an equal or greater amount of debt. As long as the capital gains debt from the original property is superseded, the investor can take out more leverage to purchase more property.
Additionally, investors looking to finance the additional costs of their replacement property may find partners willing to furnish some or all of the money. Certain sellers may also be willing to finance their own property’s purchase price to assist with the closing costs or simply to provide some additional leverage.
Replacing Debt in a 1031 Exchange
Due to the fact that any proceeds earned from the sale of the first property must be used entirely for the replacement property, questions may arise concerning leverage. Where leverage is involved, it is important to replace the debt to avoid a boot that will disallow your exchange.
For example, if your property sells for $2MM, the escrow company collects $2MM from the buyer and pays off your original loan of $1MM. The escrow company sends the intermediary the $1MM in equity that the taxpayer must then use when purchasing the replacement property.
However, because this is an exchange, the debt from the loan is considered a capital gain. Thus, the taxpayer must purchase the new property with the $1MM in equity and $1MM in new debt. This way, all capital gain has been used to purchase the new property.
Crowdfunding for Multifamily and Commercial Real Estate
Crowdfunding has gained much popularity in the past few years as an alternative to financing real estate investments. With crowdfunding, multiple investors pool their capital and can use that to either finance real estate investments for other investors and earn a fixed yield, or even a percentage of profits. Investors can also use crowdfunding to create the equity required and buy an investment property together.
Some crowdfunding companies have established platforms to invest money that qualifies for a 1031 exchange, in that if you have sold a property for a 1031 exchange, you can invest in a crowdfunded investment instead of an entire property on your own. This would allow an investor to invest in pieces of several properties simultaneously, or one large property with other investors. This is done using a Delaware Statutory Trust.
The Delaware Statutory Trust
There are a special class of properties that can be used as replacement multifamily properties that are structured as securities in a Delaware Statutory Trust. Investors purchase interests in the trust, which holds property titles and guarantees the mortgage loan. The DST allows for investors to purchase into more expensive properties that they may not have been able to afford by themselves, sometimes via crowdfunding for commercial real estate platforms. These DST properties may include retail buildings, shopping centers, office buildings, and apartment complexes that are typically valued in the 5M – 50M price range.
Leveraged 1031 Exchanges for Apartments
In summary, it is safe to say that it is a great investment opportunity to leverage the rights afforded by the 1031 exchange, specifically when investing in multifamily property. The government is giving investors the rights to invest its own money at no additional cost to the investor. Furthermore, with treasury yields as low as they are, there’s an added benefit to using leverage in order to purchase more property at a very reasonable cost. Now is a great time to use a 1031 exchange to invest in a new property, or portfolio of properties using a bit of leverage in order to bolster both short and long-term returns.