When real estate investors first learn about 1031 exchanges, they are excited to learn that they won’t have to give up their capital gains when they sell a property as long as they can put those returns toward another investment. But doing a 1031 exchange isn’t simply a case of finding another property. Benzinga recently spoke with 1031 Crowdfunding CEO Edward Fernandez about what he sees in the real estate market and how the world of 1031 exchanges is shifting.
Before becoming CEO at 1031 Crowdfunding, Fernandez was the Senior Vice President of Healthcare Real Estate Group in Irvine, California. He has personally been involved in raising over $850 million of equity from individual and institutional investors through private and public real estate offerings.
Fernandez said one of the biggest misconceptions about 1031 exchanges is that they can be used on a personal residence, which is not allowed. He also noted that many people think the taxes saved are only federal and state capital gains but may forget about the impact of depreciation recapture.
One of the great advantages of a 1031 exchange is that it can be done repeatedly. “Most investors who have not done a 1031 exchange don’t understand the fact that if you swap until you drop, meaning continue to do 1031 exchanges over and over again, there is what’s called a step-up in basis,” said Fernandez. “This means that their heirs, whoever they’re leaving their money to, are going to get all that revenue tax-free.”
The idea that a real estate portfolio that has built up equity over the years can be passed on in this manner is very appealing to investors looking to leave a legacy for their heirs. This is one reason the 1031 exchange program has been called a significant wealth builder.
There has been some political talk in recent years about the potential for abolishing 1031 exchanges, but Fernandez feels this is not likely to happen. He cited research done by Ernst and Young that showed that 1031 exchanges are a strong contributor to the economy, creating jobs and generating billions of dollars in taxable revenue. He also mentioned that changing tax law is exceedingly complicated. “There are numerous steps that legislation has to go through, so it is unlikely we will see change anytime soon: 1031 exchanges are here to stay.”
Why 1031 Exchanges Can Be Complicated
One of the reasons that Fernandez created 1031 Crowdfunding is because of the challenges many people face when doing a 1031 exchange. “The biggest hurdle that people run into is the assumption that finding a replacement property is going to be fairly easy,” he said, noting that many believe the 45-day identification period will be enough time to accomplish the process. He said that one problem people face is that they submit properties that they have put an offer on, but if the offer is not accepted, they end up paying the taxes anyway.
Benzinga asked Fernandez about an emerging trend: As investors age, they are getting out of direct property investing and using a Delaware statutory trust (DST). A DST is an investment vehicle formed by a real estate company for individuals to invest in. Investors all share ownership. A DST can be used as a 1031 exchange and is becoming more popular as people become aware of it and want to leave the day-to-day responsibilities of real estate investing behind them.
“When we first started the company back in August of 2014, I think the DST market was $300 million plus in equity,” said Fernandez. “At the peak of the real estate market in 2021, I want to say we exceeded about $10.5 billion in equity.”
Are Opportunity Zone Programs Still Worth It?
Opportunity zones were created in 2017 as part of the Tax Cuts and Jobs Act. The program is set to expire at the end of 2026 unless it is extended. However, Fernandez believes that they are still worth taking advantage of. “If investors have sold a business or they have sold some equity in the stock market, they should be looking at qualified opportunity zone funds,” he said. “Qualified opportunity zone funds allow for the deferral of taxes on personal property, not real property. Real property is for 1031 exchanges.”
He pointed out that even though the time horizon is 2026, the taxes won’t be due until 2027, and they are worth taking advantage of if you have a large tax gain not related to real estate. “I think it makes sense to take advantage of an Opportunity Zone or a Qualified Opportunity Zone fund. This allows you to defer those taxes and potentially create additional net worth for yourself by investing in those funds that are solely tied to real estate.”
