When A 1031 Exchange Is Not Always The Right Choice (2024)

Here at Realized, we help investors defer their capital gains and depreciation recapture liabilities from the sale of an investment property/properties. This is done through a tax code provision known as a 1031 exchange and here at Realized, this is typically accomplished via investment in one or more 1031 exchange-qualified Delaware Statutory Trust (DST) offerings.

As a refresher, investment properties that have appreciated in value are subject to tax on gains when sold. However, if the proceeds from that sale are reinvested in like-kind properties, within the IRS rules of a 1031 exchange, then an investor may defer the taxes that would otherwise be due. This strategy allows investors to keep more of their capital working for them. In theory, this allows them to acquire more valuable properties and produce higher cash flow than would be possible if the tax were paid.

A DST is a co-ownership structure that qualifies for 1031 exchange purposes and allows for relatively smaller investments in larger properties without landlord responsibilities - for example, exchanging $200,000 from the sale of a rental house for a “share” of a $50 million apartment complex.

Although 1031 exchanges are our business, we’ll be the first to tell you, they are not always the right decision for an investor. So why would an investor choose not to conduct a 1031 exchange? Below are nine recent examples I have experienced.

1. Tax liability is tolerable: Sometimes paying taxes is the best decision.

The first question I typically ask an investor is, “Have you or your tax advisor calculated your potential tax liability?” It’s surprising how many investors do not know the tax liabilities they would face but are determined to do a 1031 exchange nevertheless. As a first step in the potential exchange process, we recommend an investor understand that potential liability. If nothing else, this establishes the pain point - is a 1031 a “like to” or “must do” for the investor?

2. Liquidity needs: Cash is king.

Investors often need or want cash. In order to defer all tax liabilities via a 1031 exchange, an investor must reinvest all equity proceeds from the sale of their relinquished property and acquire equal or greater property value. If an investor invests less than 100% of their equity, they will owe tax on the non-exchanged amount. While a partial exchange may be a viable option for some investors, it’s rarely the most economical as tax liabilities from an investment property sale are not a linear equation (in fact, it’s possible to receive no tax deferral benefits when reinvesting smaller portions of the proceeds). Please note that there may be some ways to get cash out of a valid exchange. Stay tuned for our upcoming blog on exchange alternatives and liquidity options.

3. Not eligible: Sorry to tell you...

We hate to disappoint, but occasionally we receive inquiries where we have to let down taxpayers with hopes of conducting a 1031 exchange. The two most common situations we encounter that are ineligible for exchange are the sale of a primary residence and “flippers.” Both are excluded for the same reason: In order to be eligible for a 1031 exchange, the relinquished property must have been held for productivity in a trade or business or for investment.

Primary residences are specifically excluded from 1031 exchanges as, by definition, they are held for personal use, rather than investment or business purposes. However, homeowners do benefit from the IRC 121 exclusion on the gain from the sale of a primary residence to the tune of $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly.

Likewise, a “flip” does not qualify for exchange purposes. Following the held for investment or used in a trade or business clause, IRC section 1031 states that property "held primarily for resale" does not qualify for an exchange.

4. Legal entity issues. A difference of opinion.

In order for a 1031 exchange to be valid, the investor must follow the same taxpayer provision. The legal entity that acquires the relinquished property must be the same legal entity that sold the relinquished property. For instance, if the previous property was acquired by an LLC, then the new property must be acquired by the same LLC. This means if the LLC has 4 members, the entire LLC (and all 4 of its members) must conduct the subsequent exchange. Note that exceptions apply to legal entities structured as Tenants-in-Common (TIC) or as a Delaware Statutory Trust (DST), both of which allow multiple partners/members to conduct a 1031 exchange individually without being tied to the group.

5. Utilizing tax losses. Use ‘em or lose ‘em.

If an investor has net operating losses (NOL) or passive activity losses (PAL) that may otherwise expire if not utilized, it may be wise to recognize the gain from a property sale when such gain may be (at least partially) offset by tax losses. We recently worked with an investor who faced a significant capital gain from the sale of highly appreciated property. The investor chose to sell off some “dogs” from elsewhere in his portfolio to offset the gains from the highly appreciated sale.

6. Sold at a loss. Turning lemons into lemonade.

When an investment property is sold at a taxable loss, there may not be a reason to do a 1031 exchange - why defer a gain when there is no gain to defer? If an investor does conduct an exchange on a property with a loss, the investor would not be able to recognize that loss until the sale of the replacement property. From a purely mathematical perspective, it is generally best to defer gains as long as possible, but recognize losses in their current term.

As a word of caution on this point, remember that the gain on the sale of a property is not the difference between what it was acquired for and what it was sold for, but rather the difference between the property’s adjusted basis and its net sale price.

7. Resetting the basis. Taking the long view.

This reason likely requires more in depth financial analysis. However, in some cases, it may make sense to forgo a 1031 exchange in order for the investor to reset their tax basis, thereby improving after-tax returns on subsequent investments. Remember that a 1031 exchange is considered a continuation of an existing investment. Thus, the exchanger carries over the basis in the relinquished property as the basis in the replacement property (subject to adjustment from acquiring greater or lower property value).

For example, if an investor acquires an investment property for $100,000, depreciates it to $50,000, sells for $200,000 exchanging into another $200,000 property, the investor’s basis in the replacement property is only $50,000 - the amount carried over from the previous property. However, if the investor forgoes the 1031 exchange and instead acquires the new $200,000 property as a non-1031 exchange transaction, then the investor’s basis in the new property is equal to its purchase price of $200,000. The analysis an investor would consider here is the amount of tax liability due from not conducting an exchange compared to the additional depreciation allowance gained from acquiring the new property outside of an exchange.

8. Can’t find a suitable replacement property. Deferring taxes is not an investment strategy.

A common saying around the Realized office is, “Deferring taxes is not an investment strategy!” Simply put, bad real estate is bad real estate even if it is acquired on a tax-deferred basis. An exchanger’s 45-day identification period can move pretty quickly, and too often, we’ve seen investors rush into acquiring a replacement property for the sake of deferring taxes. Investing in real estate is often a major financial decision with a long-term investment horizon. If an investor cannot find the right property based on their personal investment objectives and comfort level, perhaps walking away may be the best solution.

9. Qualified Opportunity Zones (QOZs). A QOZ fund might be a better tax shelter than a 1031 exchange.

To continue deferring taxes using a 1031 exchange, you’ll have to keep executing a 1031 every time you sell a property. Otherwise, taxes on the sale proceeds will be due. There’s a continuous cycle of rolling out of a 1031 and into another. This cycle can be terminated upon the owner’s death, at which time the owner’s heirs receive a step-up in basis and do not have to pay taxes. For owners who are still alive and want some tax benefit from their investment, death is likely to be a high barrier to entry.

There is another way to defer property taxes and, in some cases, avoid taxes altogether. By investing the proceeds of the relinquished property into a QOZ fund, investors can enjoy tax benefits. These benefits come in two forms.

First is the deferral of taxes until 2026. That tax bill will be due in 2027 but at a 10% step-up in basis. The second option is to hold the QOZ investment for at least ten years. At the exit of the investment, investors do not have to pay taxes on gains earned in the QOZ fund.

Another potential benefit of a QOZ fund is refinancing prior to the 2027 tax bill. Investors can use refinancing proceeds to pay off tax bills. Refinancing distributions are income tax-free.

By using the above options, investors can end or avoid a 1031 cycle. With potential tax-free distributions from QOZ project refinancing proceeds, investors can pay off their tax bills.