Everything You Need to Know About 1031 Exchange Options and Alternatives
A 1031 exchange is a transaction that permits commercial real estate investors to exchange one property for another “like kind” property of equal or greater value, and, as a result, allows them to temporarily avoid paying capital gains taxes on the sale of the initial property.
To defer their capital gains tax burden, the sale proceeds from the first property must be reinvested into the replacement property within a certain amount of time. Only when the investor sells the second property will they have to pay their capital gains taxes, though they can instead choose to use another 1031 exchange to exchange that second property for a third. This process can actually be done indefinitely, allowing some investors to avoid paying capital gains taxes for decades.
While they can be highly beneficial for investors, 1031 exchanges can be complex, and there are a variety of timelines and rules that an investor must follow in order to avoid running afoul of the IRS. In addition to their complexity, there are a variety of legal structures that can be utilized for 1031 exchanges, each which has their own benefits and disadvantages. Plus, there are a variety of types of 1031 exchanges as defined by the IRS, including simultaneous exchanges, delayed exchanges (which give an investor more time to find a property), reverse exchanges, and improvement exchanges (which are ideal for developers).
In addition, it should be noted that 1031 exchanges are not right for every situation-- are they’re not the only way that investors can defer paying some or all of their capital gains taxes upon the sale of a commercial property. As we’ll discuss, Qualified Opportunity Funds, 721 exchanges/UPREITs, and deferred sales trusts are also useful ways to deferring an investor’s capital gains tax burden.
In this guide, we will discuss a variety of 1031 exchange structures, types, and alternatives in order to give real estate investors a clear idea of their options when it comes to delaying or deferring capital gains taxes.
Defining Capital Gains in The Context of 1031 Exchanges
Before diving into the various 1031 exchange options and alternatives available to investors, we should define exactly how capital gains taxes work. When an investor purchases a property, the price they pay is considered to be the property’s “cost basis.” This basis is boosted by any price appreciation the property may experience, but is reduced by depreciation, the normal wear and tear that a property experiences over time.
In general, multifamily properties are depreciated over 27.5 years and non-multifamily commercial properties are depreciated over 39 years. This means that a percentage of the cost basis of the property is reduced by a small percentage each year due to depreciation. Investors can “accelerate” their depreciation deductions using a cost segregation study, but that’s a topic for another article.
In the end, the capital gain is calculated by taking the difference between the property’s cost basis and the property’s sales price. For instance, if a property’s cost basis was $1 million and the property sold for $1.5 million, the property would have experienced a gain of $500,000 ($1.5 million - $1 million). The exact capital gains taxes an individual will need to pay are determined by their tax bracket, which is determined by their taxable income.
As of 2023, there are 3 capital gains tax brackets; a 0% bracket, a 15% bracket, and a 20% bracket. At a 20% bracket, the investor in the example above would need to pay $100,000 upon the sale of the property, which exemplifies just how important it is to avoid or defer paying these taxes.
It should be noted that there are both short and long-term capital gains taxes; the numbers we have mentioned are for long-term capital gains (for assets held for one year or more), as most commercial real estate (with the exception of fix and flip scenarios) is held for multiple years. Short-term capital gains are taxed at the taxpayer’s ordinary income tax bracket.
The Four Legal Structures for Properties Using 1031 Exchanges
In general, 1031 exchanges can be utilized for properties that are held in four different types of legal structures; Delaware Statutory Trusts (DSTs), fee simple ownership, net lease properties, and tenants in common (TIC) ownership. Below, we review a bit of each ownership structure.
Delaware Statutory Trusts (DSTs): Delaware Statutory Trusts (DSTs), are perhaps the most popular ownership structure for investors that wish to utilize a 1031 exchange. DSTs allow multiple investors to each hold a fractional interest in the holdings of the trust. Unlike many other structures, the trust generally must be established by a DST Sponsor, a professional real estate firm that will acquire the assets for the investors and manage the trust. DST properties can hold a variety of real estate assets and are not limited to single properties. A property can be transferred into a DST in as little as 3 days, which is one of the reasons why it’s such a popular option for 1031 exchanges, which typically require that both the sale of the initial property and the purchase of the new one must be finished in 180 days.
Fee Simple Property: Fee simple ownership is the most direct ownership structure, gives the owner the most control over the property, and can be ideal for owner-managed properties. Fee simple can be utilized to use a 1031 exchange from a rental property to a vacation home (in certain circumstances).
Net Lease Property: Net lease properties are properties that are rented to a tenant under a net lease, typically a single net, double net (NN), or triple net (NNN) lease. All net leases transfer much of the property expenses to the tenant rather than the landlord, with each type of net lease transferring progressively more financial responsibility to the landlord. The strictest type of net lease, NNN lease, may even require a tenant to make repairs to a building in the cases of fires or natural disasters. Net leases can be ideal for investors, as they pass a lot of risk onto the tenant, and are often long-term, 10-year+ leases with built-in rent increases. Net lease tenants are typically regional or national businesses with a good reputation and credit history, which further reduces risks for investors. Net lease properties are often owned using a fee simple ownership structure, which is best for 1031 exchanges, but they can be owned using a variety of other legal structures.
Tenants In Common (TIC) Property: Tenants in common (TIC) is a real estate ownership structure that allows each investor, or “tenant in common” to own a portion of the property equal to the percentage of funds they contributed to its purchase (or purchase and rehabilitation). In general, TIC properties are purchased with all cash, though group loans or fractional loans are sometimes available (though these loans can carry additional risk and are not offered by many lenders). Whether the TIC property is purchased with cash or partially funded with a loan, many investors will refinance the property after a certain time period, and distribute the cash back to the original investors. TIC properties can also be leased out via a single net, double net, or NNN leasing structure.
In addition to these legal structures, properties owned via a single-member LLC are also eligible for 1031 exchanges. Properties held through LLC partnerships are also technically eligible for 1031 exchanges, but they need to step through a few hoops first, using what’s called a “drop and swap” or “swap and drop” strategy. Essentially, the LLC will need to dissolve, take several other steps, and eventually re-organize under a Tenants in Common ownership structure. In general, partnerships are not legally eligible for 1031 exchanges.
The Four Main Types of 1031 Exchanges
In addition to the varying legal structures for properties utilizing 1031 exchanges, there are multiple types of 1031 exchange options, each of which is best for slightly different circumstances. These include:
Simultaneous Exchange: Perhaps the most common type of 1031 exchange option, a simultaneous exchange occurs when the original property is sold and the new property is purchased simultaneously. This can be a challenge in many situations, as timing both deals to close at the same time may not be practical, and, in addition, an investor may need to sell a property quickly, but may not have yet identified a suitable exchange/replacement property.
Delayed Exchange: A delayed exchange permits an owner to take 45 days to identify a replacement property and 180 days to complete the purchase. This is generally the absolute time limit on 1031 exchanges, with the major exception of Presidentially Declared Disasters, such as the COVID-19 pandemic, hurricanes, or other natural disasters.
Reverse Exchange: A reverse exchange allows the investor to purchase the replacement property prior to selling their existing property. Reverse exchanges are a great choice for when an investor needs to buy a property quickly.
Improvement Exchange: Unlike other forms of 1031 exchanges, which focus on existing buildings in workable condition, an improvement exchange permits an investor to build or rehabilitate a new property of equal or greater value than the initial one. This can be ideal for developers or merchant builders (as well as for distressed property investors), who can delay their tax burdens while continuing to develop or rehabilitate new properties.
Why 1031 Exchanges Don't Always Work (1031 Exchange Issues)
Unfortunately, 1031 exchanges don’t always work out as the seller intended. The most common reason for the failure of a 1031 exchange is that the seller simply cannot find an eligible like-kind property within the allotted timeline (this is why it’s always a good idea to start looking well before you intend to sell a property).
In addition to not finding a suitable replacement property, some investors may decide to do everything themselves, without a facilitator. This is a big mistake, as a successful 1031 exchange requires a document called a constructive receipt, which can only be obtained by working with a qualified facilitator.
In other cases, a seller may unintentionally fail to comply with other receipt requirements or may make other documentation errors that make their attempted 1031 exchange invalid.
Finally, a seller may not underestimate or overestimate the value of their property, and, as previously mentioned, the new property must be of equal or greater value to the initial property if the exchange is to be successful.
Below, we’ve listed a few common alternatives to the 1031 exchange, some of which may be better choices for investors in certain situations.
1031 Alternative #1: Investing in a 1031 Syndication
If a typical 1031 exchange sounds too complex, expensive, or time-consuming for you, but you still want to get 100% of the benefits of the exchange, you may want to consider exchanging your personally-held real estate for shares in real estate syndication managed by someone else. Syndications involve multiple investors coming together to purchase one or more properties, and generally consist of limited partners (LPs), who simply invest money in the deal, and general partners (GPs), who put together the deal, purchase the property, and actively manage the asset.
The benefit of a investing in a syndication is that everything is done for you, but the drawback, of course, is that you aren’t in direct control of the investment. Another benefit of being a LP in a syndication is that you can potentially invest in much larger, institutional-grade properties that you might not have been able to afford yourself. Plus, as an LP, you generally won’t be liable if anything bad happens, such as a lawsuit or a foreclosure (though you could lose your investment).
However, trading in personally-held real estate for shares in a real estate syndication can still be somewhat complex. To roll your capital gains into syndication using a 1031 exchange, you generally must invest by becoming a tenant in common (TIC), which can be legally complex and results in a lot more paperwork for the syndication sponsor. Therefore, sponsors will likely only allow this if you are investing a significant amount of money (i.e. at least $500,000 to $1 million+, depending on the size of the deal).
If you don’t use the TIC structure, the IRS will classify your shares in the syndication as private securities, not real property-- and, since a 1031 exchange requires a transfer of “like-kind” property, you can’t simply exchange your personal ownership stake in a property for shares in a syndication. There may be other ways to get around this legal barrier, but this is the most common solution. Therefore, anyone wishing to attempt investing into a syndication using a 1031 exchange should be especially careful to get expert legal assistance.
1031 Alternative #2: Investing in a Qualified Opportunity Fund
For investors who want to delay their capital gains tax burden, but don’t want to go through the process of using a 1031 exchange, a Qualified Opportunity Fund is still an option.
Qualified Opportunity Funds are investment vehicles intended to facilitate investment in Opportunity Zones, which are economically distressed areas nominated and identified by state governments and confirmed by the federal government (i.e. The U.S. Treasury and IRS).
There are currently 8,764 Opportunity Zones situated across the 50 U.S. states, Washington D.C., and five U.S. territories. Opportunity Zones were created via the Tax Cuts and Jobs Act in December of 2017, and the Act outlines various tax benefits that investors can receive by investing in Qualified Opportunity Funds, which themselves must invest the majority of their assets in real estate or businesses within pre-identified Opportunity Zones.
If an individual experiences a capital gain from any asset, including real estate, stocks, bonds, collectibles, or other assets, they can reinvest that money into a Qualified Opportunity Fund and get tax benefits based on their holding period:
5-8 Year Holding Period: 10% reduction in capital gains taxes
7-10 Year Holding Period: 15% reduction in capital gains taxes
10+ Year Holding Period: Capital gains taxes are eliminated completely
As you can see above, holding assets in Qualified Opportunity Fund for more than 10 years offers something that not even a 1031 exchange can provide; the full elimination of the investor’s entire capital gains tax burden. In general, most investors-- unless they are already well-established developers, will not want to open an Opportunity Fund themselves due to the complexity of these types of investments, and will instead want to invest in a fund managed and operated by outside professionals.
However, it should be noted that Qualified Opportunity Funds do have annual deadlines, after which investors will not be able to defer their capital gains taxes from the previous year. For example, an investor must place their funds in a Qualified Opportunity Fund by June 27, 2024, in order to defer their 2023 capital gains taxes. In addition, the Opportunity Zones program expires in 2028, meaning that 2027 is the last year that investors can use Qualified Opportunity Funds to reduce or eliminate their capital gains taxes.
1031 Alternative #3: 721 Exchanges/UPREITs
While quite popular, syndications and Qualified Opportunity Funds are far from the only way to defer one’s capital gains taxes from the sale of real estate. Another alternative is called a UPREIT, or “Umbrella Partnership Real Estate Investment Trust.” In this type of legal structure, an investor (which can be an individual or a partnership) actually does not sell their property to a separate buyer; instead, they contribute it to the REIT exchange for shares.
In general, this transaction, which is referred to as a 721 exchange, involves the initial investor selling their property to a subsidiary of the REIT, referred to as an Operating Partnership (OP), and they will get a specific number of OP units. OP units can generally be converted to shares in the REIT, and investors can usually avoid paying gains on ther initial property until the OP units or the underlying property are sold.
However, these types of deals can differ greatly in their structure, and it may take a certain period of time until the investor’s shares “vest,” meaning that they cannot sell them immediately. In addition, the REIT may also want to sell off the initial investor’s property sooner than the investor might want, which would require them to pay capital gains taxes earlier than they had hoped. Therefore, it’s important for investors to understand exactly what they’re agreeing to when utilizing a 721 exchange.
Just like investing in a syndication as an LP, using a 721 exchange to invest in a REIT allows an investor to take a hands-off approach, which can be beneficial, but also gives them little to no control over how the investment is managed.
1031 Alternative #4: Using a Deferred Sales Trust
A deferred sales trust is yet another alternative to a 1031 exchange. Unlike 1031 exchanges, which generally only allow the transfer of real property, deferred sales trusts allow investors to sell property, companies, partnerships, or other investments and exchange them for other assets, like CDs, stocks, bonds, real estate, private investment vehicles (private equity shares, hedge fund shares, angel investment equity, etc.), and collectibles.
To engage in this type of transaction, the seller transfers their assets to the deferred sales trust, which is typically managed by a third-party professional services firm. The seller will generally work with the trust to receive a portion of the profits per month or quarter, depending on how much income the seller wants and how long they want to defer their taxes. This can be ideal for investors who don’t want to purchase a new property immediately (or at all), or retirees who want a monthly or annual income without paying a ton of capital gains taxes.
Deferred Sales Trusts and Failed 1031 Exchanges
In some cases, if a 1031 exchange has failed, the seller’s qualified intermediary can transfer the funds into a deferred sales trust. Unlike 1031 exchanges, deferred sales trusts do not have strict time limits, which can provide investors additional time to find a suitable replacement property.
In Conclusion: Real Estate Investors Have a Variety of Options To Defer Capital Gains Taxes
When it comes to deferring capital gains taxes, 1031 exchanges are, by far, the most popular method utilized by real estate investors. However, as we’ve reviewed in this article, not all 1031 exchanges are alike. 1031 exchanges can be conducted using a variety of different legal structures, each of which have their own rules and specifications. There are also four different types of exchanges; simultaneous, reverse, delayed, and improvement exchanges.
Just as importantly, however, there are a variety of ways to defer capital gains taxes without utilizing a 1031 exchange, including deferred sales trusts and 721 exchanges/UPREITs. In the end, each individual investor’s situation is unique, and each investor has different needs and risk tolerances.
No matter which option an investor chooses, capital gains tax deferral from the sale of real estate is a complex subject, and any investor looking to safely and compliantly reduce their tax burden should surround themselves with a team of experts. This includes experienced professionals including real estate CPAs, real estate lawyers, and qualified exchange intermediaries (if they do wish to do a 1031 exchange).