What is a 1031 Exchange?
A 1031 Exchange is a capital gains tax deferral strategy that allows an investor to delay paying capital gains taxes on the sale of real estate property. If the property is an investment, and they immediately use the proceeds to reinvest in another property, they can defer capital gains taxes on that property.
A 1031 Exchange is a fantastic tax deferment tool, but the IRS has very specific rules and limitations for it to apply. Additionally, President Biden’s proposed 2024 budget looks to close this “like-kind exchange loophole,” meaning that the 1031 exchange is at risk of being eliminated altogether. Let’s look at the limitations of a 1031 exchange and why many investors are considering Deferred Sales Trusts instead.
1031 Exchange Rules and Limitations
The Asset Must Be Real Estate
A 1031 Exchange only applies to real estate held for business or investment purposes. It can only be applied to a former principal residence under a set of very specific circumstances. So, if you are looking to delay paying capital gains taxes on the sale of your home, a vacation property, or any other kind of investment, you are out of luck.
The Properties Exchanged Must Be Like-Kind
With a 1031 exchange, you are essentially swapping one property for another, and the tax deferment only applies if the second property you invest in is “like-kind.” This is a somewhat vague qualification but generally means that you must invest in another real property for business or investment purposes, and the real estate must be in the United States.
The Exchange Must Happen in a Narrow Window of Time
Once you sell your property, the cash goes to an intermediary. Then, you have 45 days to designate up to three replacement properties you wish to purchase. The IRS says you can identify three properties as long as you close on at least one.
You then have 180 days from selling your old property to close on the new property. If you can’t meet these time requirements, you will lose the 1031 status and will owe 100% of the capital gains taxes.
When a Deferred Sales Trust is Preferable
Your Asset is not Real Estate
If you want to sell anything besides an investment property, a 1031 exchange will not work for you as a method of tax deferral. By contrast, a Deferred Sales Trust can be used to delay capital gains taxes on any highly appreciated asset–vacation homes, stocks, cryptocurrencies, artwork, or a business.
You Don’t Want to Reinvest in Property
Let’s say you’ve been managing rental properties for years and are ready to branch out into other investments. A 1031 exchange will only work if you reinvest into another “like-kind” property–you’d have to put your money right back into investment properties.
If you want to diversify your portfolio, a 1031 exchange won’t work for you, but a DST will. You can direct your deferred sales trustee to reinvest the proceeds from your assets into bonds, mutual funds, stocks, or a REIT, among other options.
You Want Time to Make the Best Investment
The biggest risk of a 1031 exchange is running out of time. You only have 45 days to identify replacement properties and 180 days to close the sale. You are at the mercy of the seller–if he or she decides to renegotiate or walk away, you have to find and close on another property before the 180 days are up, or you are on the hook for the full taxes on your capital gains.
In contrast, you can leave your gains in a DST for months or even years while you look for the right investment. You won’t pay any taxes while you wait, and you can even reinvest your money so that it is working for you while you look for the next opportunity.
Benefits of a Deferred Sales Trust
There are a host of reasons to consider a Deferred Sales Trust as an alternative to a 1031 exchange. A DST is far more flexible than a 1031 exchange, allowing you much greater control, the ability to diversify, and no time constraints.
You can lower your overall risk by diversifying your portfolio. While 1031 is limited to real estate, a Deferred Sales Trust can be used to delay capital gains taxes on any kind of asset, and your proceeds can be reinvested in nearly any kind of asset as well. This kind of flexibility will give you the freedom to maximize your returns.
Without the strict time restrictions of a 1031 exchange, you have the ability to sell when prices are high and hold your proceeds in a trust tax-free until the market drops, and you are ready to buy low. We refer to this as optimal timing, which is key to making the most of your investments.
With the future of the 1031 exchange uncertain, now is the perfect time to consider 1031 exchange alternatives. If you want an option that gives you financial freedom, diversity, and flexibility, you should consider a Deferred Sales Trust.
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Infographic
A 1031 Exchange is a strategy that allows real estate investors to defer paying capital gains taxes on the sale of property. Learn about its limitations and why investors are considering Deferred Sales Trusts instead in the infographic.
