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  • HARRY NIMA-ZEGARRA

Benefits Of 1031 Exchanges: A Guide for Physician Landlords


Real estate investments, especially in the form of rental properties, are a popular avenue for wealth building. However, as time goes by, property owners may find themselves at a crossroads. They might wish to transition to larger properties or exit the role of a landlord altogether. But the prospect of hefty taxes upon selling their existing properties is a concern they can't ignore.


Here, the 1031 Tax Exchange comes into play as a compelling solution. It functions as a tax deferral strategy, allowing property owners to exchange one investment property for another without incurring capital gains tax on the sale.



Many real estate investors use the 1031 exchange opportunity to progress from single-family rentals to more substantial assets, such as apartment complexes.


What Is A 1031 Exchange?

Consider this scenario: You decide to sell a single-family rental property and realize a profit of $500,000 before taxes. Typically, when selling a rental property, you're obliged to pay capital gains tax and depreciation recapture tax. Capital gains tax rates can vary, but for the sake of illustration, let's assume it's around 20%. Meanwhile, the depreciation recapture tax is typically set at 25%. Once these taxes are settled, your actual profit is significantly less than the initial $500,000.

This is where the power of the 1031 exchange becomes evident. If you reinvest the full $500,000 through a 1031 exchange, you can continue building your wealth without the immediate tax hit.

By reinvesting the proceeds from your initial property into another real estate venture, you preserve your capital, setting the stage for long-term wealth accumulation.

Why To Use A 1031 Exchange

Most individuals contemplating a 1031 exchange share two key objectives. Firstly, they aim to avoid receiving cash from the sale of their property. Secondly, they intend to reinvest their profits into the real estate sector, reaffirming a commitment to long-term real estate investments. These investors typically possess substantial experience and plan to make repeated use of the 1031 Exchange for years to come.

What's worth noting is that 1031 exchanges are specifically designed for investment properties, excluding primary residences from this tax-saving strategy.

The Path to Bigger and Better Properties

Many real estate investors use the 1031 exchange opportunity to progress from single-family rentals to more substantial assets, such as apartment complexes. The appeal of multifamily syndications becomes evident here. These investments offer the benefits of apartment ownership without the hassles of property management and tenant communications. Furthermore, it opens doors for investors with various budget sizes to participate as passive investors.

For single-family rental property owners looking to transition, a 1031 exchange can be an important move. It facilitates an upgrade from being a hands-on landlord to a hands-off passive investor in a multifamily syndication, aligning with your evolving real estate investment objectives.

The Tenants In Common (TIC) Structure

The operation of a 1031 exchange is relatively straightforward, often utilizing a "Tenants in Common" (TIC) structure. This structure allows 1031 investors to offload their single-family rental and channel the money into a multifamily syndication.

Within the TIC structure, 1031 investors assume direct ownership of the bigger asset, a mandatory condition for the 1031 exchange. TICs function as distinct entities, separated from the general partnership in the case of syndications. Importantly, TICs must provide returns to the 1031 investor commensurate with their stake in the property.

However, it's critical to note that for investors in a multifamily syndication who choose a more passive route without TIC structure, the IRS classifies their shares as "securities" rather than real estate. This underscores the necessity for a "like-kind exchange" in a legitimate 1031 exchange, ensuring the transition from one real estate asset to another, not from real estate to a security.

Navigating the Process

To successfully execute a 1031 exchange, a set timeline must be followed. After selling the original property, you have 45 days to identify the next real estate investment where you'll reinvest your proceeds. During this period, you won't have access to the funds from the sale. The IRS mandates the use of a qualified intermediary, also known as an accommodator, to manage the transaction.

After the 45-day identification window, you have an additional 180 days to close on the chosen property. Failing to follow these timelines may result in the obligation to pay capital gains taxes on your profits.

The Role of a Qualified Intermediary

The IRS mandates the involvement of a Qualified Intermediary in a 1031 exchange. Failure to use one may result in automatic taxation. The Qualified Intermediary takes custody of the funds while you locate and finalize your next real estate investment, ensuring the safekeeping of your proceeds.

This professional plays a crucial role in facilitating the 1031 exchange, guiding you through the process and ensuring compliance with all deadlines. Certain rules govern who can serve as a Qualified Intermediary, including the requirement that they must be independent and not related to you. The optimal time to secure a Qualified Intermediary is during the initial property's sale process.

In Closing

Leveraging a 1031 exchange to transition from your current real estate property to a bigger property or an apartment syndication offers several advantages. It enables continued wealth growth while minimizing the tax burden on your proceeds. Moreover, it provides a pathway to larger properties or multifamily real estate, a resilient asset class with a strong historical performance record.

For physician landlords seeking to upgrade their real estate investments, the 1031 exchange is a strategic and tax-efficient solution that merits consideration.


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