With a tumultuous year for the global markets and unrelenting inflation eroding personal savings globally, investors are shifting their investments to less risky ones. Apart from deferring tax obligations, a 1031 exchange offers benefits such as long-term wealth-building and portfolio diversification in 2023.
Real estate owners hoping to benefit from the 1031 exchange, sometimes called the “like-kind exchange,” could find 2023 a busy year. By utilizing the profits from the sale of one property to buy another identical one, real estate owners can use the 1031 exchange tax planning technique to defer paying capital gains taxes on the sale of a property. Owners can defer paying taxes on their profits in this way until they ultimately sell their new property, which might be years from now.
Real estate owners can also pass on their property to their heirs, who will get a step-up in basis and no longer incur any tax obligations.
Here are six reasons to do a 1031 exchange in 2023:
Skyrocketing Real Estate Industry
For rent increase, 2021 set records in the majority of US areas. Investors in these properties are beginning to see their rents stagnate. At the same time, their costs and cost of capital continue to rise due to the current slowdown in rental rates across several key asset classes, such as multifamily properties.
Several real estate investors have realized that they no longer have access to earlier benefits of owning certain real estate assets. And, what is more concerning is that they still have to deal with the prudent management costs and hassles.
Many property owners want to perform a 1031 exchange into more passive assets, such as Single Tenant Net Lease (STNL) properties. Our pipeline of 1031 exchange clients has grown dramatically over the past few months. We generally see between five and seven 1031 exchanges annually. Still, at the moment, there are nine ongoing swaps totaling $37 million, and we have had more requests from owners to meet and discuss this service than ever before. We ascribe this to the fact that many investors have seen their real estate prices rise by up to 70% over the last three years. Meaning, they no longer have access to “easy money” due to the weakening economy and increasing interest rates.
The industries with the most significant Constant Proportion Portfolio Insurance (CPPI) change over the past ten years include manufactured home parks, industrial, self-storage properties, and apartments, which present the best arbitrage potential for investors considering a 1031 exchange.
Expiring Bonus Depreciation
The Tax Cuts and Jobs Act of 2017’s 100% bonus depreciation provision ended on January 1, 2023, and decreased to 80%. The proportion will reduce by 20% annually until it expires in 2026.
This accelerated depreciation has been a fantastic tool for exchange purchasers to completely write off the cost of eligible investment property in their first year. It has been a tremendous tool to offset significant profits that year, such as those from selling a business.
Many investors recognize that the window is closing as this tax-saving option slowly expires and positioning themselves to benefit while they still can.
Importance of Cash
Typically, real estate investors over 65 who have held a home for 20 years or more gain the most from a 1031 exchange. These owners have benefited from years of depreciation and have witnessed the greatest property appreciation. Also, these owners are the most likely to be free of debt on the asset.
With interest rates on conventional loans and mortgages from many lenders now reaching 7% or higher (Federal Reserve has predicted that interest rates can go as up as 7.2% in the coming months.), debt purchasers are no longer in the running, and cash buyers, in exchange, have access to better wealth-generating opportunities.
In January 2022, the number of 1031 exchanges were limited. However, now, there is one exchanger for every one in five properties being offered. Properties from Single Tenant Net Lease (STNL) are currently selling at higher prices, compared to the last five years.
Recognized Benefits of Wealth Transfer
As baby boomers retire and start selling their companies and real estate over the next 20 years, more than $30 trillion in wealth will change hands. Much of this money is stored in real estate, which will be sold when property management becomes too much for elderly landlords to handle or when business owners retire and sell real estate assets used for their companies.
1031 exchanges are the ideal method for these owners to reinvest 100% of that equity into solid Single Tenant Net Lease (STNL) properties with no management duties, saving up to 41% in taxes in some situations.
Due to their modest maintenance requirements, reliable monthly revenue, highly creditworthy tenants, and long-term leases, single-tenant net lease properties are investors’ preferred exchange assets. In Costar, we looked at 165,000 Single Tenant Net Lease (STNL) properties and discovered that 66% are owned by private individuals, many of whom were bought through a 1031 exchange. Over the following two decades, this number will rise.
The Ability to Defer Taxes Inevitably
One of the most common justifications for 1031 exchanges among investors is the ability to save on taxes. This implies that owners can participate in as many 1031 exchanges as they like during their lifetimes while deferring 100% of their taxes. They will only ever have to pay those taxes if they sell and acknowledge the gain from the transaction. They can leave that property plus a base increase to their heirs when they pass away. So, if they decided to sell the property as soon as they took possession, their taxable basis would have been the fair market value at the time of the devisor’s passing.
This is why we refer to Single Tenant Net Lease (STNL) properties as “last mile properties” since they are frequently the last real estate investment an owner makes to protect their equity, generate steady cash flow, and leave their heirs a property free of management duties after their passing. Owners prefer to leave their children’s possessions over employment. A multifamily property is like a job that you inherit. A CVS or 7-Eleven is a professionally run and managed asset with the potential to continue generating passive income for many years, so inheriting one is like inheriting both.
The Right Time to do a 1031 Exchange
Some owners are coming to grips with the idea that, in certain circumstances, their assets are worth 20% less now than they were a year ago because they feel like they missed the boat. They believe they are leaving money on the table by not taking advantage of an opportunity.
Investors should be aware that macroeconomic conditions equally impact the future replacement property and the down-leg property if they perform a 1031 exchange from one property to another. In reality, you wouldn’t lose anything if you could have sold your asset in January 2022 for $5 million. Still, it is now only worth $4 million because your exchange property’s value has probably “decreased” by the same amount, but the cash flow hasn’t changed. The same would hold true if you traded your existing asset for one that had gained in value by 10% due to market conditions and sold your present property at a 10% premium.
