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Blog: 1031 Exchange: An Overview and Benefits for Investors

Investors often ask if we can do a 1031 exchange on a property to defer taxes on the gains upon sale. A syndication structure (apartment or self-storage) does make it more challenging to do a 1031 exchange but it can certainly be done.

Here at Alpha Equity Group, we plan to do a 1031 exchange upon the sale of each asset and bring investors along with us. And we do provide options to investors to liquidate their shares if they want to get out.

Before we get into the mechanics of the 1031 exchange, let’s dive into what a 1031 exchange is and why it is important to consider using the 1031 exchange to build your wealth.

What is a 1031 exchange?

A 1031 exchange is a powerful tax deferral strategy that was originally started in 1921 a short 3 years after the first income tax code was enacted by Congress. Since then, it has had a complicated history and has gone through several iterations. When it was first enacted, almost 100 years ago, it allowed for non-like-kind exchange provisions, but this was quickly eliminated in 1924.

The current 1031 tax code allows like-kind real estate asset exchange to defer capital gain taxes. This can only be performed with real estate capital gains (psst… there is even a strategy to be able to use this on your primary residence which we cover in this article).

Why is it important to know how to leverage a 1031 exchange?

One of the major benefits of doing the 1031 exchange is the ability to defer the tax on capital gains and to avoid depreciation recapture. However, if you sell and take the proceeds out instead of opting for the 1031 exchange you will pay the capital gains tax.

If you can continue to 1031 exchange until you die, your “basis” in the property will reset to the current value of the investment when you die as the investment is handed down to your heirs. This is called a “basis step up”. This is also why the 1031 exchange is often called a “legacy wealth play” as this allows you to never pay capital gains (or depreciation recapture) and to leave more to your family when you pass away.

Another reason to consider a 1031 exchange is to keep your capital working hard with minimal downtime. It can be very frustrating for an investment to liquidate, and then you are having to search for a replacement investment and earning no income.

All these reasons together, help you build passive cashflow now and generational wealth later and we love working with investors for the long haul in building wealth as opposed to one off investments.

How is the 1031 exchange executed?

When we have decided to sell a property, we will poll the limited partners in the entity that holds the asset to see if they want to participate in the 1031 exchange. We do this early in the sales process since the next property (called a replacement property) must be identified within 45 days of closing. Then we must close on the new property within 180 days from closing to qualify. To remain compliant with the tax code, we must use a qualified intermediary to handle all funds between the sale of the initial asset and the purchase of the replacement asset.

When we poll investors via email, we do our best to have an asset identified to exchange into, but it’s not always the case. As the limited partner investor, you will have two choices: participate in the 1031 exchange or to liquidate your proceeds.

If you choose to participate in the “exchange” your initial capital and capital gains from the sale must roll over in the exchange. Completing the survey by the requested deadline is the only action you need to take until documents are ready for signature. Depending on the next asset being purchased, if you participate in the 1031 exchange, it may also be possible to add to your initial investment.

If you do not participate in the 1031 exchange; you’ll provide disbursement instructions for how you’d like to receive your proceeds from the sale.

In either case, be sure to consult with your tax professional to understand your complete tax situation.

In Conclusion

Completing a 1031 exchange can be very tricky as there is a certain timeline and many moving parts that must be followed for it to work properly, according to the IRS guidelines. Hence, the reason why you will find that many operators choose not to do a 1031 exchange at all at the end of their deals since it takes more time, energy, and effort to complete the transaction.

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The fundamental need for housing is universal—everyone requires a roof over their head. In the United States, however, we are facing a significant shortage of housing. According to the National Multifamily Housing Council, an additional 4.3 million units will be needed by 2035 to meet growing demand. Much of this demand is driven by migration to expanding lower cost cities and away from high tax, high cost metros, a trend accelerated by the widespread adoption of remote work during the pandemic. This trend has reshaped the housing landscape, creating a compelling opportunity for investors. While there are numerous investment strategies available, each with its own set of risks, residential real estate stands out. Over the past three decades, multifamily rentals have consistently delivered the highest risk-adjusted returns in commercial real estate. Why? Because housing is an essential need, regardless of economic conditions. At AEG, we are strategically developing both for-sale and rental housing, allowing us to adapt our approach to changing market dynamics and maximize returns while mitigating risk. Here’s why we are confident in the strength of residential housing as an investment: Land is Finite: Unlike many other asset classes, land cannot be created or expanded. The supply is fixed, and the demand for housing continues to grow. In the foreseeable future, virtual spaces like the metaverse will not replace the fundamental human need for physical shelter. Residential Housing is Non-Discretionary, and It's Supported by Government Liquidity: Housing is the only non-discretionary asset class. If it weren’t, we would see similar government support for other sectors like retail, office, or industrial real estate, but we don't. The federal government provides liquidity to the multifamily housing market because it is a fundamental need. This support drives down the weighted average cost of capital (WACC), making housing assets attractive to investors. This consistent access to capital compresses cap rates, creating a floor on the market (to an extent), fueling long-term growth and demand from investors big and small. Rents Tract with Inflation, and It is Rare to See Negative National Rent Growth: Rents reset every year as cost increases are passed off to tenants via annual lease contract resets. Since the beginning of recorded history, national rents have only gone negative year over year three times: the Spanish flu of 1918, the Great Financial Crisis, and during the Covid-19 pandemic. While yearly gains in rental cashflow streams will not make you wealthy, they are without a doubt very stable cashflows, historically speaking. There is no similar liquidity for for-sale housing, but its non-discretionary nature still gives it a strong investment profile. In growth markets like South Carolina's tertiary cities, the influx of new residents is fueling demand across all price points, further strengthening the residential sector. We believe in our residential investment thesis for both macro and local fundamental reasons. If interest rates remain high, new construction will slow even further. Meanwhile, homes in desirable locations will remain in high demand as many homeowners—especially those with low-rate mortgages—are unlikely to sell. According to the latest third-quarter data from the FHFA, 73.3% of U.S. mortgage borrowers now have an interest rate below 5.0%, a decline of 12.2 percentage points since Q1 2022. This significant shift in mortgage rates creates a unique dynamic: many homeowners are effectively "locked in" to their current homes, preventing them from moving and creating a looser supply in the for-sale market. As a result, home prices are expected to remain elevated in high-demand areas. While values may remain relatively flat in real terms over the next few years, on a nominal basis, they are expected to rise, particularly in growing markets. If interest rates decrease or economic growth drives up rental demand, build-for-rent communities could become more viable. However, they are not yet penciling out as attractive investments because growth has stalled - but, that is about to reverse. Thanks to our strategy and access to land—often without burdening our balance sheet or stretching our resources—we are able to remain nimble and pivot towards the most attractive risk-adjusted yields. As we navigate an uncertain economic environment, several factors support the ongoing strength of the residential housing market: slow housing starts, higher interest rates, and a large percentage of homeowners sitting on mortgages with sub-4% rates. These dynamics, along with strong demand in high-growth areas, reinforce our belief that residential real estate will remain a compelling investment in the years to come. At AEG, our focus is on developing attainable, high-quality housing, from custom spec homes, to mini-farm tracts, to higher density townhome projects. This flexibility allows us to serve a wide range of income levels and tailor our strategy to market conditions. With a commitment to quality finishes and high end products, we appeal to buyers regardless of economic conditions, providing us with a tighter, more predictable cash conversion and days on market cycle, unlike some of our competitors. By seeking out individually parceled deals, we reduce overall risk and remain agile in our decision-making.

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