illustration depicting the 1031 exchange process in wealth management, highlighting tax deferral and reinvestment.

Investors understand the importance of diversifying their portfolios today. Doing so reduces the risk of their portfolio being depleted when one asset class drops in value. Many investors choose to purchase real estate when diversifying. However, they must understand capital gains taxes when they sell this investment property.

One way they can save on these taxes is to benefit from a 1031 exchange. Investors can defer their capital gains taxes when they purchase another property with the sale proceeds. With property values rising today, historically high prices could lead to excessive capital gains taxes. Work with 1031 exchange advisors to keep these taxes to a minimum.

What is a 1031 Exchange?

Financial experts consider a 1031 tax exchange a tax-deferred investment account used for real estate purposes. Investors can make as many exchanges as they desire, allowing them to roll over their gains repeatedly. They will only owe taxes when they keep the funds rather than reinvest them in another property. They may upgrade investment properties repeatedly while avoiding taxes on them each time. These taxes come due only when they sell the final investment property. Real estate investors can see significant savings over a lifetime using this method.

1031 Exchange Rules

Investors must understand the 1031 exchange rules to avoid legal issues or problems with tax authorities. When purchasing real estate for investments, the investor must ensure it is like-kind. They cannot buy a personal residence and include it in a 1031 exchange. The property sold or purchased must be an investment or included in a business.

To receive the full tax deferral, the investor must purchase a property equal to or greater than the value of their selling property. The investor may buy multiple properties to ensure that this value is greater than the value of the sold property. When the original investment property sells, the seller only has 45 days to find a new property or properties to replace the one they have sold. The purchase must be completed in 180 days to avoid capital gains taxes.

The funds must be turned over to a qualified intermediary when the original property sells. This person must be separate from the sale and can have no financial or personal connection to the seller. Furthermore, the seller cannot hold the funds from selling the original property at any time if they wish to take advantage of a 1031 exchange.

Sadly, many people are unaware of the 1031 requirements or make a mistake even when they believe they're complying. Any mistake will nullify the exchange, leaving the investor with taxes, late penalties, interest, and more that they must pay. They may even be assessed a 20% negligence penalty.

A reverse 1031 exchange

A reverse 1031 exchange is a tax deferment strategy that allows an investor to acquire a replacement property before selling their relinquished property. This is the opposite of a traditional 1031 exchange, where the investor sells the relinquished property first. 
  • A reverse 1031 exchange can be used in situations where an investor:
  • Has found a replacement property but hasn't sold their relinquished property yet
  • Needs to settle on a replacement property to avoid losing down payment money or favorable financing
  • Can't postpone closing on the replacement property because they haven't found a buyer for the relinquished property 
A reverse 1031 exchange is more complex than a traditional 1031 exchange and requires careful planning. Some things to consider when using a reverse 1031 exchange include: 
  • Exchange Accommodation Titleholder (EAT): An EAT holds legal title to the relinquished or replacement property until it can be conveyed to a buyer. 
  • Environmental report: An investor needs to obtain a Phase I environmental report for commercial properties to ensure they aren't contaminated. 
  • Lender: If there is a third-party lender, the investor needs to discuss the transaction with them and ensure they are willing to cooperate. 
  • Tax advisor and/or lawyer: The investor should discuss the transaction with a tax advisor and/or lawyer before proceeding. 

Steps Investors Must Take When Completing a 1031 Exchange

Investors should take specific steps to avoid problems. They need to document everything, mainly information related to rental property transactions. For example, they need proof of renting the property, including contracts and payments.

The investor should also open a special bank account that tracks rental income and property-related expenses. It is helpful to keep these expenses separate from personal property. Some investors create a separate business entity for rentals, which helps protect them from potential legal liabilities.

Here’s how a 1031 exchange can promote tax efficiency and how wealth management strategies can help optimize its benefits:

1. Tax Deferral and Compounding Growth

  • Tax Deferral: By deferring capital gains taxes, investors have more capital to reinvest, which can be used to acquire a larger or more valuable property, enhancing the potential for greater returns.
  • Compounding Effect: The deferred taxes can work as additional capital, which compounds over time, especially if investors continue to perform 1031 exchanges with subsequent properties. This strategy can help investors build wealth faster than if they paid capital gains taxes each time they sold a property.

2. Maximizing Portfolio Diversification

  • Asset Reallocation: Wealth managers can help clients diversify their portfolios by identifying like-kind properties across different real estate sectors (e.g., residential, commercial, or industrial). This diversification can help reduce risk and improve overall portfolio stability.
  • Geographic Diversification: With guidance, investors can branch out into different regions or markets, providing additional layers of security and exposure to growth opportunities.

3. Wealth Transfer and Estate Planning

  • Step-Up in Basis: Wealth managers can help integrate a 1031 exchange into an estate plan. When an investor passes away, heirs can inherit the property at a “stepped-up” basis, meaning they receive it at current market value and may not have to pay the deferred capital gains tax.
  • Generational Wealth Transfer: Wealth managers work to structure exchanges in a way that ensures long-term stability and maximizes the inheritance value of assets for beneficiaries.

4. Strategic Identification of Exchange Properties

  • Investment Selection: Wealth managers use their expertise and market knowledge to identify properties that not only meet 1031 requirements but also align with an investor’s risk tolerance and income goals.
  • Replacement Property Selection: Timing is essential in 1031 exchanges, as investors must identify a replacement property within 45 days and close on it within 180 days. Wealth management teams streamline this process, helping ensure that clients meet these deadlines without sacrificing quality or value.

5. Mitigating Potential Risks

  • Market Volatility Management: Wealth managers can advise on the timing of 1031 exchanges to minimize risks during periods of market volatility.
  • Liquidity Concerns: Real estate is generally illiquid, which can be a limitation for some investors. Wealth managers assess cash flow needs and may structure a balanced portfolio to maintain liquidity while maximizing tax efficiency.

6. Optimizing Cash Flow Through Investment Structure

  • Income-Producing Properties: Wealth managers often seek properties with high income-generating potential, such as multi-family units or commercial leases, which can supplement an investor’s cash flow without needing to sell assets and incur taxes.
  • Debt Replacement Planning: To maintain tax deferral, the replacement property’s debt must be equal to or greater than the relinquished property’s debt. Wealth managers can assist in structuring this debt to maximize returns and preserve the deferral benefits of the exchange.

Real estate investors should work with a CPA or attorney specializing in 1031 exchanges. These professionals know these exchanges' legal ins and outs, what paperwork must be filed, and when. They may even help investors find their following properties to ensure they can take full advantage of the 1031 exchange. Speak with one of these professionals today to learn how to save on taxes while growing your wealth with the help of investment properties.