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Much has been written about the value of 1031 exchanges. Indeed, the ability to sell appreciated property and acquire a more lucrative property is greatly enhanced when there's no need to pay income taxes on that gain. There are some very real drawbacks to 1031 exchanges, however. A 1031 exchange may not be in the best interest of an investor if: 1. the investor has current year losses or loss carryovers, 2. the investor has suspended passive losses from the rental property that they wish to exchange, 3. the investor consistently is in the top tax bracket, and 4. the investor may not be able to replace the property in time. It is always wise to consult a tax advisor who is familiar with 1031 exchanges before starting the process. He or she can help decide whether a 1031 exchange will truly pay off.

Much has been written about the value of 1031 exchanges. Indeed, the ability to sell appreciated property and acquire a more lucrative property is greatly enhanced when there's no need to pay income taxes on that gain. There are some very real drawbacks to 1031 exchanges, however. The existence of certain unrelated tax circumstances may make it more desirable to simply sell a current property in a taxable transaction. Additionally, the complexity of 1031 exchange rules can trip up even the sawiest real estate investor.

THE DRAWBACKS

When investors begin contemplating a real property exchange, they should be aware of a few potential drawbacks. A 1031 exchange may not be in the best interest of an investor if:

* The investor has current year losses or loss carryovers (i.e. capital losses, net operating loss carryovers, etc.) A real property sale generates mostly capital gain. This means that capital losses available from other sources, such as stocks, will offset that gain. Other ordinary losses and net operating loss carryovers will also offset real property gains, dollar for dollar. If investors can use other losses to minimize or eliminate their tax on the real property gain, then they don't need the 1031 exchange provisions. They will be rewarded with a higher basis in their replacement property and increased future depreciation deductions.

* The investor has suspended passive losses from the rental property that they wish to exchange and significant ordinary income from other sources. Ordinary income is taxed federally at rates up to 35 percent. Capital gains, however, generally are taxed at just 15 percent (25 percent on real property accumulated depreciation). If investors sell their rental property, their suspended passive losses will offset their highly-taxed, ordinary income before reducing their capital gains. If, instead, they exchange their property, those suspended losses stay suspended and become associated with their replacement property. In many cases, they could pay a lower overall tax by selling their property, letting the suspended losses offset their ordinary income, and paying tax at the lower capital gain rates. In addition, they will receive a higher basis in their replacement property and increased future depreciation deductions.

*The investor consistently is in the top tax bracket and needs depreciation deductions to reduce his or her tax. Real estate investments frequently provide significant depreciation that is deductible against other ordinary income. If investors exchange their property, they get no basis increase in their new property for the untaxed appreciation in their old property. This means that their future depreciation deductions may be significantly less than they might expect. If they sell their old property and separately purchase their new property, their depreciation will be based on their entire purchase price. The value of the future depreciation deductions may outweigh the cost of the capital gain tax on the sale.

* The investor doesn't want to reinvest all of the proceeds from the sale of his or her property in replacement real estate. The 1031 exchange rules require investors to reinvest their entire net proceeds (gross sales price less broker commissions and other costs of the sale) in replacement real property in order to defer their tax. They will pay tax on any amount not reinvested (this is called "boot"), up to the amount of their total gain on the old property. If their goal is to acquire a less expensive replacement property and keep a significant amount of cash from the sale, a 1031 exchange may not be the best option.

* The investor may not be able to replace the property in time. There are strict timing rules that must be met for a 1031 exchange to succeed. Investors need to identify their replacement property within 45 days of closing on the sale of their old property. They may identify more than one potential replacement property, but the rules are complex. Also, they must close on the acquisition of their replacement property within 180 days of the closing on their old property. If their reinvestment includes new construction, the construction must be complete and paid for within that 180 day window. If they think they won't be able to complete the exchange within these time tables, they may want to skip the exchange route.

* The investor is not sure he or she wants to manage the new property. The rules require that investors exchange their old real property for replacement real property. If they need income-producing property, that property must be managed. If it's time for them to retire from the management of real estate and they are reluctant to hire a manager, then they may wish to consider a sale so they can reinvest the after-tax proceeds in a more passive or less time consuming investment vehicle.

* The investor wants to achieve diversification in geography or type of property. Although investors may acquire multiple properties as part of a 1031 exchange (provided that they meet the boot and timetable guidelines discussed above), the rules require that they invest in real property. They cannot invest in a partnership holding a diversified portfolio of real property, for example. Depending on the value of their property, this rule may seriously impair their ability to achieve diversification goals.

Finally, another potential drawback of the 1031 exchange is its permanency. The sales proceeds from the sold property must be escrowed with a qualified exchange intermediary. Once escrowed, the proceeds are unavailable to the investor (other than to acquire qualified replacement property) for the entire 180 day replacement window. Even if the investor decides to abandon the exchange transaction, the intermediary may not return the funds until the window expires.

CONCLUSION

The rules governing 1031 exchanges are complicated and the penalties are harsh. Much of the time, however, 1031 exchanges make sense and can be a smart way for investors to defer taxes on their real estate transactions. It is always wise to consult a tax advisor who is familiar with 1031 exchanges before starting the process. He or she can help decide whether a 1031 exchange will truly pay off.