The Power of a 1031 Exchange: A Smart Strategy for Apartment Building
Owners
As an apartment building owner who has managed your property for decades, you’ve likely built
up significant equity in your asset. Over the years, you’ve weathered the ups and downs of real
estate management, handled tenant concerns, and maintained your property—often without the
luxury of a property manager. Now, you might be thinking about the future: How can you reduce
the stress and time commitment of self-managing your asset while still benefiting from the
wealth you’ve built?
Enter the 1031 exchange—a powerful tool that allows you to defer paying capital gains taxes
on the sale of an investment property by reinvesting the proceeds into another similar property.
It’s a popular strategy for investors looking to scale down their property holdings or transition
into a less management-intensive asset so as you approach retirement or have a shift in
priorities.
In this blog, we’ll dive into what a 1031 exchange is, why it’s a great option for you as an
apartment building owner, and how you can use it to swap your current property for a more
passive investment—such as Delaware Statutory Trusts (DSTs) or Triple-Net Lease (NNN)
properties.
What is a 1031 Exchange?
A 1031 exchange refers to a provision in the U.S. Internal Revenue Code (Section 1031) that
allows you to defer paying capital gains taxes on the sale of an investment property by
reinvesting the proceeds into another similar property. The property you sell must be used for
investment or business purposes, and the replacement property must also be for similar
use—this is why it’s often referred to as a “like-kind exchange.“
The beauty of a 1031 exchange lies in the ability to defer taxes indefinitely as long as you
continue reinvesting in like-kind properties. Essentially, you can “swap” properties and defer
taxes on your capital gains until you sell the replacement property at a later date, at which time
you may opt to do another exchange, or pay taxes when you finally decide to cash out.
Why Utilize a 1031 Exchange?
There are several important reasons why apartment building owners, like yourself, should
consider a 1031 exchange, especially if you’re looking to transition to an asset that requires less
hands-on management.
Tax Deferral
The primary benefit of a 1031 exchange is the deferral of capital gains taxes. When you sell your apartment building, you may face significant tax liabilities, especially considering the property’s appreciation over the years. A 1031 exchange allows you to defer those taxes, which can be substantial, giving you more funds to reinvest and grow your portfolio.
Diversification and Portfolio Growth
After decades of managing a single property, you may want to diversify your investments. A 1031 exchange allows you to use the equity from your apartment building to acquire multiple properties in different asset classes or geographic areas. This helps spread out your investment risk, giving you the opportunity to hold various types of real estate, such as commercial properties, industrial real estate, or even raw land.
Shifting to a Passive Investment
If you’re tired of the day-to-day management responsibilities of your apartment building, a 1031 exchange gives you a way to transition into more passive forms of investment. One option is to exchange your apartment for Triple-Net Lease (NNN) properties or a Delaware Statutory Trust (DST), which both offer hands-off ownership with stable cash flow.
Estate Planning
Another reason to use a 1031 exchange is for estate planning. If you’ve owned your apartment building for many years, it likely has appreciated significantly. Through a 1031 exchange, you can defer capital gains taxes, and upon your passing, your heirs may benefit from a “step-up in basis”—meaning the value of the property is reset to its market value at the time of your death, which can reduce future tax burdens when they sell.
Transitioning to Less Management-Intensive Assets: NNN Properties and
DSTs
As a property owner who has spent years actively managing your apartment building, you may
find that the idea of transitioning into a less demanding investment is appealing. Here’s how a
1031 exchange can help you achieve that by rolling your equity into either Delaware Statutory
Trusts (DSTs) or Triple-Net Lease (NNN) properties.
Delaware Statutory Trusts (DSTs)
Another option that’s gaining popularity among real estate investors, especially those looking for
a truly passive investment, is the Delaware Statutory Trust (DST). A DST is a legal entity that
allows multiple investors to pool their resources to purchase large, institutional-grade real estate
assets, such as shopping centers, office buildings, or apartment complexes. When you invest in a DST, you own a fractional interest in the underlying property, and the DST sponsor (or operator) handles all of the property’s management, including leasing, maintenance, and day-to-day operations. This means that you can continue benefiting from real estate income without dealing with tenants, repairs, or property management—allowing you to focus on other aspects of your life or retirement.
One of the major advantages of DSTs is that they qualify as “like-kind” properties for a 1031
exchange, which means you can sell your apartment building and use the proceeds to invest in
a DST without triggering capital gains taxes. This is an excellent option if you want to remain
invested in real estate but want to take a step back from the operational side.
Triple-Net Lease (NNN) Properties
A Triple-Net Lease (NNN) property is a commercial real estate asset in which the tenant agrees
to pay for most, if not all, of the property’s operating expenses, including property taxes,
insurance, and maintenance. This arrangement reduces the landlord’s responsibilities, making
these properties an excellent option for investors who want a more passive income stream.
By exchanging your apartment building into a NNN property through a 1031 exchange, you can
preserve the cash flow from your original investment while significantly reducing your
management obligations. I like tenants that are recession and e-commerce proof. For example,
a Starbucks, 7-Eleven, or Aspen Dental location with a long-term lease in place might be an
ideal NNN property. These properties tend to provide stable, predictable income with minimal
oversight from the landlord.
How does a 1031 Exchange work?
Executing a 1031 exchange requires careful planning and attention to the IRS guidelines.
Here’s a quick overview of the steps involved:
Step 1 – Sell Your Property
The process begins when you sell your apartment building. The sale proceeds cannot be taken
directly by you; they must be held by a qualified intermediary (QI), a neutral third party, to
ensure that the exchange process meets IRS requirements.
Step 2 – Identify Replacement Properties
Once the sale is completed, you have 45 days to identify replacement properties. You can
identify up to three properties, or more if certain conditions are met. This step is crucial, and it’s
important to work with a real estate professional who can help you identify viable options that
align with your investment goals, whether that’s a NNN property or a DST.
Step 3 – Close on New Property
You have 180 days from the sale of your original property to close on the purchase of the
replacement property. This is a strict deadline, so it’s essential to have your financing lined up
and be ready to act quickly.
Step 4 – Enjoy Tax Referral
Once the transaction is complete, you’ve successfully deferred capital gains taxes, and you can
enjoy the benefits of your new, less management-intensive investment.
Potential Pitfalls
Although a 1031 exchange is a powerful tool, it’s important to be aware of a few potential
pitfalls:
– Strict Timelines: Missing the 45-day identification period or the 180-day closing period
can disqualify your exchange and result in paying capital gains taxes.
– Like-Kind Property Requirements: The replacement property must be considered like-
kind to your original asset, meaning it must also be for investment or business use.
– Qualified Intermediary: A professional QI must handle the exchange. It’s crucial to work
with someone who is well-versed in 1031 exchanges.
In Conclusion
For an apartment building owner who has spent decades building wealth through real estate, a 1031 exchange can be an excellent strategy to preserve your investment and reduce management responsibilities. Whether you choose to reinvest in a Triple-Net Lease (NNN) property or a Delaware Statutory Trust (DST), you can transition to more passive investments that generate income with minimal oversight.
By leveraging the power of a 1031 exchange, you can continue building your wealth while freeing yourself from the burdens of daily property management. It’s a strategic move that can offer you financial flexibility and peace of mind as you look toward the next chapter of your investment journey.