The Pros and Cons of Using a 1031 Exchange
The Pros and Cons of Using a 1031 Exchange
If you’re thinking of performing real estate investing soon, it’s highly recommended that you learn about 1031 tax-deferred exchanges and what they can mean for you and your portfolio. When used correctly, this type of exchange gives you the opportunity to increase your returns and effectively scale your portfolio. However, you should know what these exchanges are and how they work before engaging in your next real estate transaction. This guide takes a detailed look at the pros and cons of a 1031 exchange.
What Is a 1031 Exchange?
When selling one of your investment properties, you’ll be tasked with paying substantial capital gains taxes once the sale goes through. While the amount of taxes you pay depends on the income bracket you’re in, the capital gains tax rate is usually around 15-20%. Depending on the state you live in, your capital gains could also be taxed as income, which means that state taxes might be owed as well.
Should you use a 1031 exchange as opposed to a standard sale, capital gains taxes can be deferred if you reinvest your profits from the sale into a completely new property. You could also use these funds to invest in several properties. The main requirement is that the property you invest in must be of equal or greater value compared to the one you just sold.
Keep in mind that capital gains taxes are only deferred, which means that you’ll eventually need to pay them. The only way to get rid of these taxes is by leaving your investment properties to your beneficiaries and heirs.
Pros of a 1031 Exchange
A 1031 exchange has many upsides that investors can and should take full advantage of.
You Can Defer Taxes
The main benefit of a 1031 exchange is the ability to sell an investment property and reinvest in another to defer capital gains taxes as well as ordinary income taxes.
Improved Cash Flow
You’ll have more cash flow to use for another property investment. Since taxes are deferred, these funds can be immediately used on a separate investment.
It’s Possible to Reset Depreciation
You have the option of writing off the depreciation in your asset to compensate for aging, structure obsolescence, and general wear and tear. According to the IRS, investment properties have a depreciable period of around 27.5 years, which means that a portion of the property value can be deducted from your taxes for over 27 years.
The only issue with writing off depreciation is that assessors won’t have details on any improvements you make to the property, which is why the depreciation value might only apply to the value of the property when you first purchased it. By using a 1031 exchange, you can reset your investment property’s depreciable amount to a higher number for a larger tax benefit every year.
Gives You Access to New Markets
This process gives you the opportunity to diversify your portfolio and reduce risk. When implemented correctly, a 1031 exchange can take place anywhere in the U.S., which allows you to expand to new markets that have a higher potential for growth.
Cons of a 1031 Exchange
Despite the many benefits, there are a few issues of a 1031 exchange that you should consider before you get started.
Must Adhere to Strict Regulations
First, there are many regulations and procedures you must adhere to if you want to gain the full benefits of a 1031 exchange. If you follow these regulations, the IRS won’t recognize income when the property exchange transaction is performed. If, however, you make a mistake during this process, you could incur tax penalties.
You Can’t Recognize Losses
Losses in a property are unable to be recognized. Along with taxes being deferred, any losses in property value are also deferred.
Strict Timeline
You must select a like-kind property to purchase with a 1031 exchange within 45 days after the sale of your previous investment property. This transaction must close within 180 days, and there are no exceptions to this rule, so be careful.
If you’d like to sell a real estate property of yours but still expect to invest in new properties, using a 1031 exchange allows you to defer capital gains taxes and move into new markets. However, the guidelines for this exchange are strict, which is why caution is advised.