The Benefits And Risks Of 1031 Exchanges

A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred. The name comes from Section 1031 of the Internal Revenue Code, or IRC. Financial and investment firms often use the term 1031 exchange in their marketing to attract money for their syndications or to get people to sell a property to receive a commission.

In this article, I'll review some benefits of using a 1031 exchange as well as the potential risks involved, and why your business might consider doing one sooner rather than later.

Tax Deferral Benefits

A 1031 exchange allows you to defer taxes, which is the main advantage of doing one. You're deferring capital gains tax after selling a property and picking up a "like-kind" better property that can potentially cash flow way more than the previously owned one.

An example of how this would work would be to take a small multifamily property like an 8-plex and then sell it and use the money to acquire a 50-unit property, increasing your cash flow and mitigating your tenant delinquency risk more. For this to work, the 1031 exchange funds must be held in a qualified escrow account or trust account.

This is a smart strategy for when you ******want to scale to multifamily as a business seeking cash flow.

Increased Cash Flow

By exchanging a "lesser" property for a potentially "greater" property, you can increase your monthly or quarterly cash flow. "Exchanging" a property with a lower rent potential to a higher rent potential property with more units will immediately increase your cash flow.

Portfolio Diversification

Utilizing the 1031 exchange can be ******an excellent opportunity to diversify your real estate holdings into small or large multifamily properties. An example of this would be the current market where, in 2024, a lot of loans will come due in multifamily; you have an opportunity to utilize your portfolio to trade up into one of these multifamily properties or to invest with a syndicator that is acquiring one to diversify your real estate holdings.

Using a 1031 exchange to invest alongside an operator acquiring a much larger asset can be an excellent strategy for investment firms not wanting to play the landlord role 100% themselves. It also allows them to take advantage of group purchasing, a benefit of investing in multifamily.

Wealth Accumulation

Capital gains tax is a hindrance to accumulating wealth in real estate. However, you can use a strategy to defer taxes while acquiring larger and potentially more profitable assets. This way, you can beat the enemy, which is capital gains tax, until you are ready to realize those capital gains.

You can increase your company portfolio value and rental income as you continuously leverage 1031 exchanges to move from property to property.

Potential Risks

Businesses should be aware that the 1031 exchange has an identification period of 45 days from the sale of their relinquished property to identify a potential replacement property or properties depending on the value of the previous property. If a property isn't identified in this time period, the entire exchange can fall apart.

The larger the portfolio, the more difficult this can be. Imagine a company having 45 days to identify a $100M real estate asset to replace the property you all just sold. If your company is a "do it themselfer" type of company, that only invests in its own deals, this can be very difficult to make happen.

This also ties into the next risk of this strategy, which is market and economic risks, such as the sudden rise in interest rates we've experienced recently.

Imagine a company planning to start this 1031 exchange process, and then a month later, interest rates begin to rise and do so monthly until you reach where we are today. That would make it difficult to both sell the property and find another property within that 45-day identification period without having a lot of your money eaten up in interest.

To defer all capital gains tax, you must reinvest the entire net proceeds from the sale of the relinquished property into the replacement property and acquire debt on the new property that is equal to or greater than the debt on the property that was just sold and relinquished.

This creates another risk of property value and debt issues because if everything doesn't align, the exchange can fall apart because of this.

Conclusion

A 1031 exchange is a great tool your firm can consider leveraging as long as the option is available. I believe this year is going to present a lot of multifamily opportunities because loans are coming due, meaning a lot of operators will be selling.

If your company has a high equity real estate portfolio, this is an opportunity for you to either acquire small to midsize multifamily properties or to leverage the expertise of more experienced operators and invest in larger assets through "group purchasing" while also taking the landlord duties off your shoulders.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

‍