Make §1031 Like-Kind Exchanges Work for You

In spite of recent news reports showing that IRC §1031 is under attack (see our last update and a subsequent New York Times article),  the §1031 like-kind exchange remains a popular and viable strategy for deferring the entirety or a portion of capital gains taxes that would be due upon the sale of  appreciated value of certain classes of investment property, including real estate.    Many of Holm & O’Hara LLP’s clients who are incorporating §1031 like-kind exchanges into their financial strategies have opted to exchange residential property in the New York metropolitan region for commercial properties in other geographic locations to take advantage of markets which have not peaked.

Potential Benefits

Many of our clients have experienced at least one – and often all five – of these key benefits:

1. Defer Income Tax Due on Capital Gains:

  • IRC §1031 allows for deferral of capital gains taxes when investment property is exchanged for other investment property which is like kind.
  • Deferrals are indefinite, so long as the funds remain invested in like-kind property.  It is even possible to do successive §1031 exchanges or convert property into personal use property

2. Increase Income:

  • Reduction in expenses results in increased income in many – if not most – cases.
  • Transformation of a residential tenant base to a commercial tenant base also tends to generate greater income.
  • Use of leverage to buy replacement property of greater value can yield tax advantages in the form of interest deductions and increased depreciation expenses, yielding a greater return.

3. Decrease Managerial Responsibility:

  • Commercial property typically requires less owner participation than residential property.
  • Many clients choose to buy net lease property which has minimal landlord responsibilities.

4. Decrease Operating Expenses:

  • Lease terms for commercial properties frequently shift operating expenses from owners to tenants.
  • Replacement properties are often located outside the NYC metro region, and therefore have lower overall operating costs.

5. Increase Cap Rate (ratio of net operating income to original capital cost):

  • Commercial properties tend to generate a more favorable cap rate.
  • Properties outside the New York metropolitan region also tend to generate a more favorable cap rate.

Other Applications for §1031 Exchanges

Beyond a straightforward §1031 like-kind exchange, in which investment property is sold and exchanged for other investment property, there are several permutations in which a §1031 strategy can be effective.  Here are some:

  • Sell development rights (“air rights”):  Development rights can be sold and exchanged to purchase other investment property which are eligible for tax deferral under IRC §1031 like-kind exchange. 
  • Take advantage of new real estate investment opportunities:  Using a reverse §1031 like-kind exchange, it is possible under specific circumstances to identify and acquire the replacement property through a Qualified Intermediary before you are ready to sell your current investment property. 
  • Partially liquidate your investment:  Under IRC §1031, you can sell your current real estate investment, take part of the proceeds as cash and reinvest the remainder in like-kind property.  You will be liable for the income tax due on the capital gain on whatever portion of the proceeds you of the sale you decide not to reinvest.  However, you will be to defer the income tax on the portion you do reinvest. 
  • Convert a vacation property into an investment property:  Safe harbor provisions (Revenue Procedure 2008-16) allow you to defer capital gains on sale of your vacation or second home if you reinvest the proceeds in like-kind property after first converting the vacation/second home from personal to investment use under IRC §1031.  In order to do this, you must meet three provisions:  i) hold the property for investment purposes for at least 24 months; ii) rent the property out to others at fair market rates for at least two weeks during each of those two years; iii) limit your personal use or enjoyment of the property to not more than two weeks or 10% of the number of days that the property was rented to others during the previous two years.
  • Purchase a retirement home:  Similar provisions allow you to acquire a retirement or vacation home for future use under favorable tax conditions with proceeds from sale of an investment property.  You must meet the three provisions outlined above before converting the property to exclusive personal use.  Property which was purchased with 1031 funds can later be eligible for a primary residence exemption which can result in a forgiveness of taxes instead of just a deferral.   
  • Remove assets from your taxable estate:  As part of your estate plan, it may make sense to sell your current investment property and reinvest the proceeds in replacement property.  After a cooling off period, you can put the replacement property into a family limited partnership, removing your own interest from it – and excluding it from your taxable estate. 


Check out our Trusts & Estates Update for recent changes to federal, New York and New Jersey trusts and estates law and how they might impact your strategic financial and estate planning.

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