When Would a 1031 Exchange Not Benefit Me?

I get this question quite a bit. Is there ever a situation or time when a 1031 Exchange might not benefit me or would not be such a good idea? The answer, of course, is yes. 1031 Exchanges are complex tax-planning strategies that are not suitable for everyone and are certainly not appropriate under all circumstances.

The sale of any real estate should be carefully evaluated to determine the best and most suitable tax-planning strategy available for each investor. This is why investors should always visit with their legal, tax and/or financial advisors before proceeding with any 1031 Exchange. Advisors can help investors ensure that the 1031 Exchange is the best alternative for their specific situation, goals, and objectives. I cannot emphasize this enough! I know that investors like to do things themselves, and that they hate to pay advisors for their advice and guidance, but a few hundred dollars is well worth it if you can avoid a major headache later. Remember, investors often do not know what they do not know. An advisor can help you understand what you do not know, but need to be wary of.  Your team of advisors should also include a good 1031 Exchange Qualified Intermediary that can help balance each of the advisors opinions.

Having said all of that, you would generally not want to structure a 1031 Exchange transaction for the sale of investment real estate if the sale would generate an actual loss for income tax purposes. You would most likely be better off with selling the property without a 1031 Exchange so that you can recognize and write off the loss from the sale. However, there are limited situations when you might actually want to defer a loss from the sale of property by structuring a 1031 Exchange.

In many cases, an investor’s Adjusted Gross Income, also referred to as his or her AGI, might be high enough that it prevents the investor from taking advantage of his or her passive activity losses on some or all of their investment properties. The outright sale of the investment property may allow them to recognize and take full advantage of the accumulated suspended passive activity losses against other taxable income or gains. It might make more sense in cases like this to just sell a property and use up the suspended activity losses. This requires careful analysis of the investor’s overall income tax position.

Investors may also want to consider a partial 1031 Exchange where they sell property at one value and exchange into or acquire a lesser value property or what we call trading down in value. This would allow them to defer most of their taxable income tax from depreciation recapture and capital gains, but recognize a small amount to strategically offset certain other loss carry forwards. Trading down can also be an effective strategy used to reduce their overall debt service level. It is important not to automatically rush into a 1031 Exchange, but to do some carefully planning to make sure that the 1031 Exchange is the right strategy to meet your specific goals and objectives.