A 1031 exchange is a tax-deferred trade of one investment property for another. The IRS allows investors to trade an investment property and delay capital gains, provided they reinvest the profits into a replacement property. You will find this very intriguing if you are currently investing in real estate. However, before determining if a 1031 exchange is appropriate for you, examine the following pros and cons:
- Deferring Taxes
Many investors are shocked to discover that federal capital gains tax is not the only tax burden they must endure when selling real estate. There are also depreciation recapture taxes, state capital gains taxes (in some states), and possibly the Affordable Care Act surtaxes. Depending on plenty of other factors, including the state in which your property is located, you could be fronting taxes in excess of 35percent of your profits! But a 1031 exchange enables you to defer these taxes continually — provided you reinvest your funds back into real estate.
- Potentially Higher Annual Cash Flow
Consider for a moment that you were capable to net $2 million in cash by selling a rental home that had been held and depreciated for 10 years and that the capital gains taxes payable were $950,000 (sounds crazy, but a good likelihood if you stay in California.) If you meant to pay the capital gains taxes and advance the unused $1,050,000 in the market gaining 5% on your money, you would be eyeing at an annual cash flow of about $52,500.
But what if you were fit to invest the entire $2 million to purchase another real estate asset producing a 5% return (we’ll overlook the use of debt which would enhance your returns further). You’d now be looking at an annual cash flow of $100,000.
- Asset Accumulation
A 1031 exchange is a compelling wealth-building tool. There are no absolutes on the number of consequent exchanges, providing an investor to exchange into progressively bigger properties over time. With proper estate planning, you can give assets to your heirs, who may hold a “step-up in basis” of the asset to its current market value, efficiently allowing your heirs to then trade the asset at its fair market value without giving the capital gains taxes.
- Property Management Relief
If your current property requires a lot of management, a 1031 exchange could provide you to exchange it for one with limited day-to-day management burden. One option to acknowledge is a net leased (NNN) property where the tenant is liable for all maintenance and operating expenses. Another option is to swap into a Replacement Property Interest™ in one or more high-quality, professionally maintained properties. (Check our guidebook on this topic for more info)
- Strict Regulations
There are several rules and regulations to comply when executing a 1031 exchange, and you may find some complexity when trying to follow. For example, you must name one or more potential replacement properties within 45 days following the sale of your relinquished property. Then, you must acquire replacement property within 180 days of the sale of the first property. Also, the replacement property needs to have a purchase price and mortgage balance equivalent to or higher than the relinquished property being sold.
There are many added regulations to obey, and if done clumsily, you could have to pay taxes and even penalties. Fortunately, a skilled and experienced Qualified Intermediary can assist you along this process.
- Reduced Basis for Depreciation
In a 1031 exchange, the value of depreciation that can be exacted on replacement property is based upon the adjusted basis of the relinquished property at the point of the exchange. This means that the value of depreciation you can demand on your replacement property will generally be lower than if you had got the replacement property without the use of a 1031 exchange.
- Not Tax-Free
It is critical to note that this exchange is tax-deferred, not tax-free. This implies that if or when you finally sell your replacement property, without another exchange, you will be liable for paying taxes on all of the capital gains and depreciation recapture you have delayed through prior exchanges. However, as mentioned above, this is possibly avoided through careful estate planning.