Swaps: a primer

Post by 
Christopher Ostertag

Investors who’ve been around the real estate block a few times invariably know what swaps are. And we’ve written before about some of the financial and tax advantages associated with private real estate. But swaps can be complicated business — and worse, to the uninitiated, they might sound like something they’re not.

So today, let’s dive in and talk about swaps.

What are swaps in real estate investing?

The first thing to know is what swaps aren’t. Chances are, if you’re hearing a real estate investor talk about swaps — say, in marketing materials or on a conference — they aren’t talking about giving you their house in exchange for your house. But that definition does get used sometimes in single-family markets between private sellers, so it’s important to make sure you know what context the term is being used in.

Most real estate investors use the term ‘swap’ to refer to something called 1031 Exchanges.

Here’s how they work. Investors in commercial real estate typically want to capitalize on two avenues to profitability: cash flow and appreciation. The former refers to rents collected while you hold the asset. Hopefully, for assets like apartment buildings, your rents received exceed the value of your expenditures (mortgage payment, maintenance, etc.). That’s one source of income — and it’s important for many investment strategies to acquire stable, cash-flowing assets from day one.

But investors who hold properties for longer — especially if they buy into growth markets or when inflation strikes — are hoping for appreciation. The problem: when you earn returns on the sale of an appreciated property — that’s right — you owe tax. With short-term capital gains tax matching your ordinary income tax bracket, that’s a great way to cough up as much as *checks notes* 37% of your returns. In this economy?? That’s a no for us.

Long-term capital gains tax is a bit friendlier: because it’s applied in graduated thresholds maxing out well below 37%, it means less of a tax hit. But even a 20% loss is substantial, so investors are usually better-off finding ways to defer tax liability. Money now is worth more than money later; that’s why banks charge you interest on loans.

Sooo . . . how does it work?

Section 1031 Exchanges are called, well, Section 1031 Exchanges because the name refers to a section of the Internal Revenue Code. If you’re looking for some light bedtime reading, feel free to click this nice blue link. If you’re not, allow us to summarize.

  1. When you divest a real asset (think land and buildings), no taxable event occurs IF
  2. You acquire a like-kind asset (which is why swaps are also sometimes called like-kind exchanges).
  3. You have 45 days to designate the replacement asset, and 180 days to close on it (although, fun fact: you can also acquire the new asset before selling the old asset — it all just has to happen within 180 days).

The first question is: what is a like-kind asset? Fortunately for investors, it doesn’t mean you have to buy something materially identical to the asset you sold. What it does mean is that both properties have to be located in the United States, and property for personal use often can’t be swapped with property for commercial use. But swapping out investment properties is usually unproblematic. Swapping rental properties for a vacation home, on the other hand, might cause problems.

The catch: if you swap two properties that are unequal in value, you’ll end up owing what’s sometimes known as “the boot” — which is capital gains tax on the difference in value.

The next question is:

When do investors benefit from swaps?

We’ve all heard the fable about the kid who turns a penny into a car by making an unbearably tedious series of trades. It’s a bit overblown, if you ask us. But, for active real estate investors who want to stay in the game and continue acquiring assets — but feel that some assets in their portfolio have fulfilled their potential — swaps are a way to defer tax liability while continuing to adjust your portfolio.

In cases like that, swaps allow investors to perform an acquire/appreciate/sell/acquire loop — especially if it’s on a shorter timeline — without subjecting their returns to crushing tax liability. Of course, the tax does need to be paid eventually, but especially for a fledgling operation, keeping liability in the future frees up liquidity that’s critical to getting off the ground and acquiring a well-diversified portfolio. And, in theory, the tax liability doesn’t necessarily ever have to be paid. So long as the chain of real assets continues in like kind, and you don’t exchange the asset for, say, cold hard cash, capital gains tax won’t become due.

The bottom line? 1031 Exchanges are a powerful tool for investors to defer one of the largest sources of liability for real estate investing enterprises. In many cases, there’s no good reason not to use swaps to preserve momentum — especially for operations that continue to grow, and need to realize appreciation on one success story so they can finance the next one.

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