Real Estate Exit Strategies: 1031 Exchanges and Other Tax-Efficient Options for Investors

Real estate investment strategies can change over time, and you may find yourself asking whether you want to continue owning real estate or whether you should sell and consider other investment alternatives. There are many investment alternatives, but the problem with selling real estate to get into them is that capital gain recognition may be triggered, and you may have less equity to reinvest.

However, there are a few options that may help investors exit or reduce direct ownership of real estate while potentially reducing, excluding, or deferring capital gain recognition, depending on the strategy and the taxpayer’s facts and circumstances. Many of these strategies are complex and their suitability is totally reliant on your particular facts and circumstances, so be sure to talk with your tax or legal advisor before pursuing any of these alternatives.

Option 1: The 1031 Exchange

Internal Revenue Code Section 1031 applies to property held for productive use in a trade or business or for investment, and it allows for the deferral of capital gain recognition if the property is exchanged for like-kind property. Section 1031 applies only to qualifying real property, not personal property. The broad definition of like-kind can help investors in many ways. For example, owners tired of the headache of managing several properties can leverage their equity into one larger one.

IRC Section 1031 also has broad geographic application for real estate throughout the United States. For example, a couple who own rental houses in California but have kids attending college out of state may be able to exchange their California rentals for qualifying investment properties that their children can rent from them while attending college, if the rental arrangement satisfies applicable requirements. Any rental to family members should be reviewed carefully to confirm fair-market rental terms, investment intent, and compliance with Section 1031 requirements.

Many investors exchange real estate throughout their lives and leverage their unused tax dollars to purchase more real estate that generates greater and greater returns. Some investors may have lower taxable income in retirement, which can affect applicable capital gains tax rates. However, the actual tax result depends on the taxpayer’s facts, including holding period, depreciation recapture, net investment income tax, and state tax. Some investors then leave their real estate holdings to heirs, who may receive a basis adjustment at death, which can reduce or eliminate built-in gain for income tax purposes, depending on the facts and applicable law.