Most Tax-Efficient Alternatives to a 1031 Exchange

1031 Pros
Sep 12
5 min read

Few people look forward to the tax season that follows the sale of an investment property. That’s why so many people investigate 1031 exchanges. With this technique, investors can roll the taxes into the basis of the new property. While it works, 1031 exchange alternatives exist.

We’ll explain what a 1031 exchange is, and we’ll outline some alternatives that can also help to keep your profits.

What Is a 1031 Exchange?

A 1031 exchange is a coordinated real estate transaction involving two investment properties. This technique gets its name from the Internal Revenue Service (IRS) code 1031, which states that no gain or loss is recognized on the trade of property held for use in trade or business.

A 1031 exchange must involve a like-kind trade of properties. Typically, commercial real estate is like kind to other commercial real estate. So you can use a transaction like this to sell something like an office park and buy an apartment building.

However, you can’t use an exchange like this to buy something you intend to live in as your primary residence. The assets involved must be for investments only.

What Are the Drawbacks?

While a 1031 exchange comes with plenty of perks, including the ability to defer potential capital gains taxes. However, it’s not the right choice for everyone.

For example, a 1031 exchange comes with tight time frames. Per IRS rules, you must identify a property you want to buy within 45 days of the sale, and you must complete the transaction within 180 days. Some investors struggle to meet this deadline.

In addition, the properties involved must be used as investments. People who want to opt out of the property management business may want to simply cash out and use the proceeds to buy a dream home. Taxes are involved, but for some, that’s okay.

1031 Exchange Alternatives to Consider

While any investor could simply sell a property and walk away with the profits, there are other options that could help you keep your money. These are some of our favorites:

1. Delaware Statutory Trusts

A Delaware Statutory Trust (DST) is a tool several investors can use to purchase one property. To create a DST, the IRS says the owners must create official documents and file them. This isn’t something you can create with a verbal contract or a handshake.

In a typical DST, several investors share an asset like an apartment building. They pool their resources to purchase it, and they aren’t required to do anything to maintain it. A separate company runs the building, and the investor keeps the profits.

A DST doesn’t come with immediate tax benefits (unless it’s purchased via a 1031 exchange). However, this option does allow you to share the risk of a new property with several other people. It’s a smart way to diversify your portfolio without sole ownership.

2. Deferred Sales Trust

A deferred sales trust (also called an installment sale) allows an investor to spread out sales payments over two or more years, and the seller isn’t required to pay taxes on those payments until they’re actually received. This method defers tax burdens, and it could reduce the overall bill by (potentially) lowering a seller’s tax bracket.

This method is relatively new, and the IRS has been examining transactions to ensure that they’re legal and fall within the guidelines. It’s important to work with a talented professional who has extensive experience in these transactions to ensure that they’re done within a legal framework.

3. Qualified Opportunity Funds

A qualified opportunity fund is a tool that allows people to invest in businesses located in economically distressed parts of the country. These areas need funds and attention, and to make investors participate, the government may use tax investments, including the opportunity to reduce capital gains taxes.

Individuals can’t participate in these plans, the IRS explains, but LLCs or partnerships can do so. However, these companies are required to file paperwork that proves they exist to participate in the funds.

These are delicate transactions, but they can help you to avoid a big tax bill while diversifying your portfolio.

4. UREITs (721 Exchanges)

An umbrella partnership real estate investment fund (UPREIT) is also known as a 721 exchange. Here, an investor exchanges real estate in return for partnership units, which are eventually converted into shares of the REIT.

This tool gets its name from IRS Section 721(a), which states that no gain or loss is recognized to either the partnership or any partners if the contribution is made in exchange for an interest in the partnership.

A tool like this can allow you to let go of an underperforming property while investing in something that comes with less legwork. You’ll keep your funds circulating while lowering your workload. And the tax benefits can be significant.

5. Tenancy in Common Cash Out

All states recognize something called a tenancy in common. This tool allows one asset (like a building) to be owned by several people (called co-owners). Each co-owner has the right to use the whole building, even though they don’t own the entire thing.

A tenancy in common is typically used for something like a condominium in a vacation area. Many people own it, but they roll through the use of it depending on their various work schedules.

Per IRS rules, these partnerships work if they have two or more members classified as a corporation or partnership. Some buildings have many more.

When you sell your shares in these products, the sale could be taxable. However, since you only own a part of the building, your bill might be smaller than it might be for an entire asset.

6. Cash Out Refinance

If you’re interested in selling your primary home without a big tax bill, a cash out refinance could be a good tool. Your home is appraised, and you get a mortgage that’s larger than the one you have now. The difference comes to you as a lump sum you could use for almost anything, including home improvements.

This approach doesn’t come with a tax penalty, as you’re not actually selling the product. However, you’ll face fees associated with getting the loan and paying interest on the balance. You’ll also need to qualify for the loan, which isn’t easy for everyone.

Explore Your 1031 Exchange Options

For many investors, a 1031 exchange remains the best way to preserve assets and build a healthy real estate portfolio. Don’t let fear or a lack of expertise keep you from tapping into this opportunity. Get the help you need from 1031 Pros.

We specialize in these delicate transactions, and we’ve handled hundreds of them. With our streamlined process, we can ensure you comply with all the applicable IRS rules and avoid immediate tax payments. Contact us to get started.