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Should You Sell Your Investment Property or Use a 1031 Exchange?

M. Ian Colville
4 min read
Should You Sell Your Investment Property or Use a 1031 Exchange?

Should you sell your investment property or consider utilizing a 1031 exchange? This is a question frequently pondered by real estate investors, particularly those who focus on long-term property holdings rather than flippers. The concept of a 1031 exchange, also referred to as a like-kind exchange or a Starker, revolves around the opportunity for investors to defer capital gains tax while “selling” a property.

Many investors become serial exchangers, using this tool to help them build wealth as they replace older properties with more valuable ones, and defer tax liability in the process. In addition to the tax deferral benefit, there are several other advantages, as well as a few potential drawbacks, to the 1031.

In this article, I provide some food for thought about times you might want to sell as opposed to exchange. The wisdom in deciding to use a 1031 exchange will depend on your specific financial situation and goals, so always consult a tax professional before deciding if a 1031 exchange is right for you.

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What Are the Rules of a 1031 Exchange?

The basic rules of a 1031 exchange are straightforward. Under the Internal Revenue Code Section 1031, only exchanges of real property qualify. The range of real properties allowed is broad, including improved or unimproved properties. However, certain stipulations must be met to exchange vacation homes. It’s important to note that properties held primarily for sale, such as fix and flips, do not qualify. Generally, the property being exchanged must have been held for investment purposes for at least a year. For more in-depth information on the rules and requirements, you can check out our comprehensive article on how a 1031 exchange works.

Related: How a 1031 Exchange Can Make You Millions

Questions to Ask When Deciding Whether to Sell or Exchange

When faced with the decision to exchange or sell, it is important to look at the big picture. Sure, a tax deferral always sounds great, but it shouldn’t be the only factor under consideration. Here are a few other things to carefully think about before making your final decision.

What Is Your Potential Tax Liability?

At face value, it always sounds better to defer/avoid paying taxes, but you should know what your potential tax liability will be if you were to sell the property. You might be surprised—it could be tolerable or even acceptable.

How Badly Do You Need the Cash?

Sometimes life happens, and you just need the cash.

Are There Any Sticky Legal Entity Issues?

If the property to be sold was purchased through a legal entity (an LLC, for example), that same legal entity must purchase the replacement property. If all members of the entity cannot agree on what is to be done, the most expedient course might be to sell and distribute the funds.

Note that exceptions apply to legal entities structured as Tenants-in-Common (TIC) or as a Delaware Statutory Trust (DST), both of which allow for multiple partners/members to conduct a 1031 exchange individually without being tied to the group.

Do You Have a Loss That Can Be Offset?

If you have a net operating loss or passive activity loss that is expiring soon, it might make more sense to sell rather than exchange. You may be able to (at least partially) offset the gain by the tax losses.

What Is Your Capacity?

Do your current life priorities allow you enough bandwidth to find replacement properties and move swiftly to close within the required 180 days? Can you identify good properties for the exchange within the allotted 45 days?

If you can’t find a replacement property that stands alone as a good investment, it may be better to sell and take the tax hit. Why saddle yourself with a dog?

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1031 Exchange vs. Selling Your Investment Property

When it comes to maximizing the potential of your investment property, weighing the benefits of a 1031 exchange against selling the property outright is crucial. Each option offers distinct advantages that can significantly impact your financial outcomes.

Benefits of a 1031 Exchange:

  1. Tax Deferral and Preservation of Capital:

    • A 1031 exchange allows you to defer paying capital gains tax on the sale of your investment property, preserving your capital for reinvestment.
    • By deferring taxes, you have the potential to leverage the entire sale proceeds to acquire a new property, maximizing your investment potential.
  2. Portfolio Diversification and Flexibility:

    • Through a 1031 exchange, you can exchange your property for a different type of real estate asset, enabling portfolio diversification and potentially mitigating risks.
    • The flexibility of a 1031 exchange allows you to adapt your investment strategy to changing market conditions and capitalize on emerging opportunities.
  3. Enhanced Cash Flow and Income Potential:

    • By strategically choosing a replacement property through a 1031 exchange, you have the opportunity to acquire a property with higher income-generating potential, leading to improved cash flow and financial returns.
    • The ability to generate increased cash flow can provide a stable income source and contribute to long-term wealth accumulation.

Benefits of Selling Your Investment Property:

  1. Immediate Liquidity and Freedom:

    • Selling your investment property provides you with immediate access to the proceeds, allowing for financial flexibility and the ability to allocate funds according to your needs.
    • It frees you from the responsibilities and management obligations associated with property ownership, providing a sense of freedom and reducing potential stress.
  2. Simplified Investment Strategy:

    • Selling your investment property allows you to simplify your investment strategy by eliminating the complexities and ongoing involvement of managing real estate assets.
    • It provides the opportunity to explore alternative investment options or redirect funds towards other ventures.
  3. Mitigation of Market Risks:

    • Selling your investment property removes your exposure to potential market fluctuations, reducing the risk of financial losses.
    • It offers the opportunity to realize profits at a favorable time and potentially capitalize on other investment opportunities outside of real estate.

Deciding between a 1031 exchange and selling your investment property without utilizing this tax-deferral strategy requires careful consideration. While a 1031 exchange offers advantages such as tax deferral, preservation of capital, portfolio diversification, and enhanced cash flow, selling your property provides immediate liquidity, simplified investment strategy, and mitigation of market risks. Assessing your investment goals, financial situation, and long-term objectives will help guide you in making the most suitable choice for your individual circumstances.

Related: 3 Common Mistakes Investors Make in a 1031 Exchange

Conclusion

There are many pros and a few cons to 1031 exchanges. Successful 1031s can be a powerful tool for building wealth through real estate. But there are strict requirements and a few pitfalls to be aware of—especially for those new to 1031 exchanges. Be sure to work with qualified professionals to ensure all the rules are being followed and the exchange fits with your current tax situation.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.