Managing real estate capital gains with like-kind exchanges (Section 1031)

• Capital gains taxes may be deferred with proper planning and the use of like-kind exchanges.
• Identifying the right replacement property and determining how best to manage it going forward is one of the crucial steps to helping ensure the success of a like-kind exchange.

• Due to the level of complexity involved in properly implementing a like-kind exchange, it is important to consult with a knowledgeable advisor.

If the value of your real estate has appreciated significantly, you may find yourself facing a large capital gains bill if you decide to sell. If you are planning to buy a new investment property, however, in many cases, you may be able to defer the tax gain. In specific circumstances, the Internal Revenue Code (IRC) allows an investor to postpone paying taxes on the unrealized gain if one real estate investment is exchanged for another (or several) if the proceeds are reinvested in ’like-kind’ property. This type of like-kind exchange, or 1031 exchange, allows real estate investors to reinvest the proceeds from a sale on a pre-tax basis.

Basic requirements¹

There are several basic requirements for completing a like-kind exchange.

• The property must be held for investment or used in a trade or business. Inventory and personal use property are not eligible.
• The relinquished and acquired properties must be of like-kind. Like-kind property is property of the same nature, character, or class. However, most types of directly held real estate qualify as like-kind property, so farmland can be exchanged for an apartment building or a vacant lot can be exchanged for a strip mall.
• Unless you are directly exchanging one piece of real estate for another similarly priced property, a qualified intermediary is used to hold the proceeds received from the sold property and apply them to acquire the new property.
• Replacement properties must be identified within 45 days of the sale of the relinquished property. You may identify up to three replacement properties, irrespective of the value of the properties, or you may identify as many properties as you like provided that the total value of the properties does not exceed 200% of the fair market value of the relinquished property.
• A separate rule allows you to identify more properties than would be allowed by these two restrictions as long as you acquire at least 95% of the value of the identified properties by the required date.
• The acquisition of the new property must be completed by the earlier of 180 days from the sale of the relinquished property or the due date of the acquirer’s Federal income tax return. Filing an income tax extension extends this deadline, causing the 180-day rule to control.
• To qualify for full tax deferral, the value of the acquired property must equal or exceed the value of the relinquished property, including debt. If the acquired property is worth less than the relinquished property, then only a partial deferral may be available.

Reverse 1031 exchanges, also are allowed, where you can acquire a new property before the existing property is sold. While the basics of completing a reverse exchange are relatively straightforward, the implementation can be complicated so it is important to consult with your professional tax advisors and identify an experienced qualified intermediary to make sure that the tax deferral will be respected by the IRS.

It is worth noting that personal property and securities investments, including real estate investment trusts (REITs) are currently not eligible for 1031 exchanges.

Over the course of a lifetime and through a series of like-kind exchanges, you can exchange properties many times while potentially deferring taxes. In fact, current law allows for taxes on capital gains to potentially be eliminated by holding exchanged real estate until you pass away.

This means that - if you are holding a replacement property when you die, and your heirs inherit it - the step-up in basis to fair market value for the property (versus the property’s initial purchase price) may allow the property to then be sold by your heirs without capital gains tax being a factor.

Like-kind exchanges can be done with family members or other related parties. However, there are rules to prevent related parties from swapping low-basis assets for high-basis assets to reduce income taxes. Generally, both parties must hold the exchanged properties for two-years for the deferral to work, but there are exceptions to these rules that are worth discussing with your tax advisor.

Buying and selling assets in today’s market presents its own set of challenges. Interest rates have made the cost of capital more expensive to property purchasers. Coupled with high demand for quality properties, you could potentially face challenges identifying a reasonable investment within the 45 day window.

Additionally, when factoring in the costs of selling the original property and the costs of acquiring the replacement property, you may need to buy an asset with higher yield than you sold in order to replace the cash flow you received from the sold property.

Fortunately, there are strategies to help accomplish this, including:

• Acquiring a different asset class with higher yields (e.g. retail vs. multi-family).
• Acquiring assets in a location or market where higher yields are normal (secondary markets vs. core markets).
• Acquiring assets of a different 'class' (e.g., Class A Office vs Class B Office).
• Finding an asset or assets to buy at below market price (off-market or distressed).

Nonetheless, successfully identifying and managing real estate assets to potentially enhance cash flow (higher yields) and creating appreciation requires both general and specific real estate experience, such as local market knowledge, property management capabilities, and asset management. Managing real estate from a distance may lead to challenges, complications, and/or missed opportunities that can make the difference between a successful investment and a problematic one.

Contact your advisor to learn more about the planning and real estate asset management services to assist you in the full life cycle of owning investment real estate. Comprehensive analysis, planning, and execution is available to help you achieve your short, medium, and long-term investment goals if you are considering a 1031 exchange.

¹ Internal Revenue Service, “Instructions for Form 8824 (2020), https://www.irs.gov/instructions/i8824#idm139888469375040

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Wells Fargo & Company and its affiliates do not provide tax or legal advice. This communication cannot be relied upon to avoid tax penalties. Please consult your tax and legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are filed.

There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.