1031 Exchange Investments: 5 Alternatives to Consider Before Investing
August 1, 2022
The real estate sector is packed with investment opportunities that can earn you cash actively or passively. Among these opportunities is the 1031 exchange.
Whether you’ve heard this term before but don’t know what it entails, or you’re seeking 1031 exchange ideas, you’ve come to the right place. This article will help you understand the nature of these investments and also provide a comprehensive list of profitable 1031 exchange investment options to consider when diving into this investment strategy.
Without further ado, let’s get into the details.
What is a 1031 Exchange?
The term “1031 exchange” is derived from Section 1031 of the United States Internal Revenue Code (IRC). This Investment form permits individuals to circumvent capital gains taxes after selling a real estate and reinvesting the proceeds within specified time constraints in similar properties with the same or slightly different value. In a transaction, like-kind assets must also be of comparable value.
Boot is the difference in value between both exchange properties. Suppose a replacement property’s value is less than that of the former; the cash boot (difference in value) is taxed. If a personal or dissimilar property is used to complete the deal, it’s boot as well, but it doesn’t invalidate the transaction for a 1031 exchange.
Also, fees and expenses influence the transaction’s value and, as a result, the likelihood of a boot. Settling expenditures using 1031 exchange investment funds include broker’s commission, attorney’s fees, intermediary fees, filing fees, etcetera.
Understanding Depreciation and How it Relates to 1031 Exchanges
Depreciation is a property’s percentage cost that’s written off yearly to account for aging. After selling a property, you calculate capital gains taxes using the asset’s net-adjusted tax basis, which is the property’s actual cost, adding capital improvements and subtracting depreciation. The depreciation accumulated over the holding period is recaptured and taxed. For unprepared individuals, the tax bill might be a shock.
Because the amount of depreciation recapture grows over time, it may entice you to choose from the several 1031 exchange investment options to prevent the huge taxable income increase that accompanies depreciation recapture.
1031 Investment Options to Consider
Below is a list of the best 1031 exchange investments to consider:
Delaware Statutory Trust Property
Investors in a Delaware Statutory Trust (DST) property own a portion of the property rather than the entire property. An investor can hold properties in different geographic regions, with different asset classes, renters, and even property managers, by separating their investment capital into numerous properties.
Investors who use a DST typically invest in high-quality assets that they wouldn’t be able to afford otherwise. These properties are managed by experts, making them passive investments in which the DST sponsor firms (asset managers) are in charge of all day-to-day real estate ownership activities.
If a 1031 exchange investor wants to replace debt, the DST loans are non-recourse to the investor, meaning the investor doesn’t have to sign personally for the loans.
Debt-free DSTs are accessible with no long-term mortgages hampering the assets for investors unwilling to risk lender foreclosure and don’t require debt replacement in their 1031 exchange since they’ve previously paid off their mortgages and completely own their property.
Triple Net (NNN) Properties
Investors can buy a Triple Net (NNN) property, meaning the commercial tenant pays rent, taxes, insurance, and some or all of the property’s maintenance. Diversification can be difficult because NNN properties can range in price from $1.5 million to over $10 million. Also, investors may become overly invested in one asset class, one tenant, and one location.
Management concerns that many owners overlook include ensuring that insurance is current, tenants are prompt with their property tax payments, and how to re-lease the house if it becomes vacant. Otherwise, it’s a lucrative way of earning passive income in commercial real estate.
Qualified Opportunity Zones
Following the Tax Cuts and Jobs Act, Qualified Opportunity funds are similar to 1031 exchanges that invest in tax deferral and elimination. Such funds are eligible for real estate investing or running a business in an economically distressed neighborhood starved of investments.
Therefore, the investment risk may be greater. In addition, the investing timeline can be up to ten years, meaning you’ll hold your fund for a long time. If you’re considering investing in this way, keep in mind that the funds may only be used for a business or single-property investment; ergo, it is undiversified.
Tenants In Common Cash-out (TIC)
Several investors seek to boost liquidity to take advantage of future purchasing opportunities, while also deferring taxes via a 1031 exchange. With a Tenants-in-Common (TIC) investment, you possess a fractional stake in a commercial, multifamily, self-storage, or other forms of investment property.
TIC cash-out is a technique in which the investment property is acquired with no leverage and is debt-free at its acquisition time. The property may then be refinanced at 40 to 60 percent loan to value after a year or two, essentially giving investors a major amount of their initial principal back tax-free in the form of a cash-out refinance.
In this case, the remaining equity in the investment remains in the TIC, allowing investors to receive possible payouts while still having access to a significant portion of their assets.
Oil and Gas Royalties
To acquire the right to dig a well, an oil and gas business, known as the operator, signs an oil and gas lease with the mineral owner. Royalty and mineral interests allow investors to diversify their portfolios away from traditional real estate and into a different asset class with distinct economics. In this agreed-upon sector, the operator digs wells to extract the hydrocarbons beneath the surface.
The oil and gas corporation pays all drilling and running costs and undertakes drilling risks and obligations. Along with qualification for a 1031 exchange, if the mineral and royalty interests are like-kind, the extra tax benefit is a tax depletion allowance of around 15 percent (depending on the program).
You can learn more about these 1031 exchange investment options by clicking the link in the text.
1031 Property Types
When deciding what to do after selling your asset, the following list of 1031 exchange property types is a great place to start:
- Residential property
- Commercial property
- Vacation rental property
- Agriculture property
- Conservation property
- Timberland investment property
- International property
- Oil, gas, mineral, water, and ditch rights
- DST, NNN, and TIC
Conclusion
The 1031 exchange investment options mentioned above provide opportunities for real estate investors to profit. However, it’s crucial to understand the details before jumping into one. For example, learning how depreciation works in a 1031 exchange investment is something every investor must prioritize for a successful investment.
However, other 1031 exchange alternatives that didn’t make the list exist, such as the UPREIT (721 Exchange), which provides investors with increased liquidity and exit alternatives for their real estate investment.