Most individuals that dabble in investment real estate understand the power of IRS Tax Code Section 1031. This particular section is one of the principle reasons that real estate is chosen by the uber wealthy as an investment class to store and transfer wealth. Utilization of this tax benefit is often referred to as a “1031 Exchange”. With a 1031 exchange sellers are allowed to essentially trade their existing business or investment real estate for another real estate investment, and defer paying taxes at the sale. A discussion of the benefits of this tax deferment in real estate investment and the associated strategies are the topics of thousands of articles. Alternatively, this article will focus on five additional benefits of a 1031 exchange besides the power of tax deferment.
1. Increased Income Potential: The term “like-kind” is commonly used when discussing a 1031 exchange because the tax code specifically refers to “like-kind” exchanges. This term is perhaps the most misunderstood phrase in all of real estate. Too many people perceive “like kind” to be real estate specific, i.e. a residential rental needs to be exchanged for a residential rental or raw land can only be traded for raw land. This is a misconception. The 1031 section was originally created after World War One to facilitate equipment upgrades for factories and to provide inducements for the industrial revolution to forge forward. It was not until the 1980s that the IRS universally accepted the use of Section 1031 for real estate exchanges. Thus, the term “like kind” in this section takes on a less specific meaning. Any real estate held for investment or commercial purposes can be exchanged for any other real estate used for the same purpose. This allows the owner of a residential rental returning 4.5% or even negative cash flow raw land to upgrade into a triple net (NNN) leased investment grade commercial building paying 6%! Consider this real-life example: A Salt Lake couple owned a residential rental that generated $1,700 per month of income. From this revenue the couple paid taxes, property insurance, water and garbage fees. Additionally, they had the expenses of re-painting and replacing the carpets with new tenants. After all was said and done, they realized less than $1,400 per month in real income. The husband managed the tenants and property and the wife kept the books. After utilizing the power of a 1031 Exchange this couple owns portions of a bank and a dollar store. Both properties have long term leases in place and the couple receives $2,100 every month, deposited directly into their bank account – guaranteed by two of the most secure corporations in America. This 1031 transition created a 50% increase in net monthly revenue without the hassle of property management, thus creating a stream of passive income they can enjoy in perpetuity.
2. Escape The Triple T Monster (Tenants, Trash, and Toilets): Owners of residential rentals are often chained to these properties in their retirement years. Many owners think that they cannot sell the properties they have toiled over for 30 years without relinquishing 33% of the value to Uncle Sam. They think that the Triple T Monster has a relentless grasp on their retirement lifestyle and is not about to release them. That is, until they discover the power of a 1031 exchange and move their residential properties into investment grade triple net (NNN) leased buildings. In a NNN lease the tenant (not the landlord) is responsible for maintenance, taxes, and insurance. The Triple T Monster is slain and the monthly time commitment for the property owner is reduced to simply checking their bank account to verify that the corporate guaranteed funds have been deposited.
3. Move Markets: Many people enter into the real estate investment market by purchasing something they understand such as the house down the street or the duplex in a nearby town. Investors don’t always realize that the 1031 tax code allows you to exchange into a property anywhere in the US. With the booming economy in Utah everybody wants to invest here. Values of residential rentals are at all-time highs. Because investors are able to 1031 exchange between markets, an individual has the potential to sell in Salt Lake City and buy in Hawaii. Think of the possibilities!
4. Diversification By utilizing a partial ownership product offered by Millcreek Commercial owners can utilize a 1031 exchange to diversify their portfolio to create a “Custom Real Estate Investment Portfolio” (REIP). Consider another real-life example: A Washington couple had owned a single-family residential rental for nearly 50 years. In their retirement they traded this single asset for ownership interests in two different commercial buildings and a bank. All three properties are guaranteed by different investment grade corporations and are located in three distinct markets. This diversification brings peace of mind and a sense of security as they travel the country visiting their grandchildren.
5. Change Property Types Because of the broad definition of “like kind” as used in IRS code, property owners can exchange between property types. For example, the owner of farmland can sell to a developer and purchase income-producing commercial properties. The 1031 Exchange is an exceptionally powerful wealth management tool that is entirely underutilized by small investors. For more information about 1031 exchanges you can contact Millcreek Commercial Properties at 801-899-1943. We can provide you basic information and direct you to qualified advisors. About the Author: Kevin G. Long is a national commercial real estate executive with offices in Salt Lake City, Utah. He was the founding Broker and COO of CBC Advisors. In partnership with Brandon Fugal they grew Advisors into a national commercial real estate brokerage company with 30 offices from New York City to Los Angeles. In 2018 Colliers International purchased CBC Advisors. Kevin has started a new national real estate company, Millcreek Commercial Properties, that focuses on breaking down the barriers to owning commercial real estate as an investment.