As most know, 1031 exchanges enable investors to swap one investment property for others while deferring state tax (if applicable), as well as federal capital gains tax, depreciation recapture and net investment income tax.
Although the 1031 exchange mechanism is a federal statute, there are certain state-specific considerations that might influence its relative appeal.
For example, the ability to defer state tax could be particularly attractive for people who own property in California, since it has by far the highest capital gains tax rate (13.3%) of any state in the country. In fact, New York (10.9%) and New Jersey (10.75%) are the only other states that exceed 10%, while eight states (Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas and Wyoming) have no capital gains tax.
Clawback Provision
Another critical consideration is the clawback provision in California law, which is shared by only three other states: Massachusetts, Montana and Oregon. This provision comes into play if you initially participate in a 1031 exchange but decide not to utilize one for a subsequent sale.
For instance, buying a property in California for $200K and eventually selling it for $1 million would typically entail an obligation to pay capital gains tax on the $800K profit. But let’s say you conduct a 1031 exchange for that property, defer the capital gains tax and acquire another property in Texas as part of the exchange. If you sell that Texas property at a later date but choose not to do so via a 1031 exchange, California will come back to you with a tax bill for the sale of the initial property.
Local Trend
Because the value of real estate is generally higher in California compared to most other states, we’re seeing a trend of people selling assets here and then going to a different state where they can get more for that amount of money.
One common scenario might be for a retiree to sell their property in California because they want to live out their retirement in Florida. So they plan to do a 1031 exchange on the California property, buy a Florida investment property and then rent that out for a couple years before moving into it.
While this strategy would defer the federal capital gains tax, and there’s no such tax in Florida, they’d still be on the hook for the California capital gains tax because the purchased property would have become a primary residence. In my interactions with investors, hardly anyone seems to know about that clawback provision in California, but its ramifications can significantly impact the advisability of a real estate strategy.
Accredited Investor
Another important aspect to understand is that you don’t need to be an accredited investor to conduct a 1031 exchange, but this status is necessary to utilize a Delaware Statutory Trust (DST) within an exchange. DSTs allow individuals to co-invest in direct real estate properties, providing a stake in these assets without requiring investors to hold or manage them.
As an illiquid asset, a DST is considered a private-placement security. Non-accredited investors cannot invest in such assets, due to concerns that they might not have the means to obtain cash from other resources in the event of a financial emergency.
Accredited investors, meanwhile, must make more than $200,000 annually as an individual, $300,000 with a spouse, or have a net worth of over $1 million, not including the value of their home. A 2020 rule enacted by the U.S. Securities and Exchange Commission (SEC) also extended accreditation to people with specific licenses, experience or educational background, such as investment advisors and brokers.
However, a sweeping bipartisan vote of 383-18 in the House of Representatives recently passed a measure designed to expand the pool of accredited investors. Under this bill, the Equal Opportunity for All Investors Act, accredited investor certification could be obtained after successfully completing an examination designed by the SEC. If it eventually becomes law, the bill would be a game-changer for the DST industry, removing a significant barrier to entry.
That said, 1031 exchanges and the utilization of DSTs within them aren’t necessarily applicable or advisable for any given investor or situation. It’s important to conduct appropriate research and due diligence before making an investment decision. If you’d like to learn more about the tax advantages of DSTs, as well as the pros and cons of 1031 exchanges, please visit our website at https://www.1031crowdfunding.com/.
Author Edward Fernandez is CEO and founder of 1031 Crowdfunding.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements are speculative in nature and involve a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC, member FINRA, SIPC.
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