Why 1031 Exchanges Rule the Rental Property Investment World

The growing frustration over the pro-tenant political atmosphere in California has been further fueled in recent years by AB 1482 and more recently by the COVID-19-related legislation of AB 3088, SB-91, and now AB 832. Not to mention the 140 local moratoriums throughout the state that continue to handcuff landlords from evicting tenants and in some cases even preventing them from raising rents. Many are fed up with holding residential investment assets in the state and have decided it is time to get out! The major hurdle in selling investment property is finding means of deferring capital gains on the sale.

There is a mechanism for doing just that by continuing the business of rental property ownership by exchanging one or more properties under IRS Section 1031 of the US Tax Code. All investors are aware that any amount a relinquished property is sold over the basis is taxable. The basis is  the difference between the current net sales price of the property(minus depreciation plus improvements) and the original purchase price . The government will assess capital gains taxes of up to 33% on any amount in excess of the basis which could equate to hundreds of thousands of dollars or even millions depending upon current value/sales price.

The ability to defer taxes on the capital gains of an investment is one of the most viable wealth building tools for investors in the history of the business. Not only can investors defer taxes indefinitely, but their heirs would also receive a step-up in basis when the investor passes away and pay little or no taxes depending upon when they sold the asset(s)!!! The only catch is to always exchange when selling because any investors who does not utilize a 1031 will pay capital gains on the current sales as well as any other exchanges previously deferred.

The timelines for a 1031 exchange are extremely important to avoid a failed exchange. An investor has 180 days (six months) from the date of the close of escrow on the relinquished property to close on the sale of the replacement. There is also a 45-day identification period for the investor to submit a list of properties they plan to purchase. If, for any reason, the investor is unable to purchase one of the properties on the list, the IRS will consider this a failed exchange subject to capital gains.

An investor may seek to purchase multiple properties that equate to value of the relinquished property, in which case they can identify as many properties as they want. The caveat is the total value of all of the replacement properties cannot exceed 200% of the value or sales price of the relinquished property. There is also the question of properties where owner lives on site and has an income producing asset. Section 121 and 1031 of the Internal Revenue Code can be used to obtain the $250,000.00-$500,000.00 exemption for primary residences if the seller has lived on the premises two of the last five years. An example of this would be an owner of a duplex, who lives in one unit and rents out the other.  They could sell the property, take an exemption under Section 121 of up to $500,000.00, and exchange into another property using the value of the portion of the property they rented out. This can be done  as long as the replacement property fits the definition of ‘like-kind’ and is not a ‘trade-down’ in value(remember: the value of the replacement property must exceed that of the relinquished property or the IRS considered that amount a ‘boot’ subject to capital gains taxes).

Some owners prefer to do a reverse exchange where they close on the replacement property first then purchase the existing property. The problem with this is most lenders will not loan on a reverse because the property would not be initially owned by the buyer. The property has to be placed in the name of the accommodator who will then lease the property back to the buyer under a triple net lease. Then there are duplicate title transfer fees as well as increased 1031 exchange accommodator fees that almost double in transaction of this sort. A reverse may work for an investor purchasing all-cash or for someone with a great working relationship with their lender, but it is not for everyone.

The challenges of a 1031-exhange are further complicated by the current market where in Southern California we see a ‘seller’s market’ with more buyers than inventory. There is also the matter of realizing investment objectives and finding a replacement that meets or exceeds those goals. In some areas we even see cap rate compression with augmented value/price without higher NOI figures because buyers are willing to pay more for C and D properties due in part to low interest rates and the threat of rates increasing over the next 16 months.

There is a solution to risking a failed exchange because of a saturation of investors seeking replacement properties. Many investors have looked to other product types of income producing assets in other states. This option has been effectively utilized by many investors who have received a higher rate of return on triple net commercial retail investments. There are some investors who even pick up several single family home rentals as replacement property in an exchange and can see a nice return with minimal management as well as limited expenses.

Our office has partnered with several out of state commercial brokers who have an inventory of triple net retail properties for sale. Any interested investors can contact our office at (310) 538-6884 or click here for a list of out of state properties.

By M.A. Williams 10/9/21