Interested in doing a 1031 exchange or wondering if it’s the right option for you?
If you are, you’re not alone. A 1031 exchange is a popular option for real estate newcomers and seasoned investors alike. However, it can also be a complicated process, and its benefits and drawbacks may not always be clear.
What is a 1031 Exchange?
A 1031 exchange is arguably the most valuable tax advantage available to real property owners. Stemming from section 1031 of the Internal Revenue Code, a 1031 exchange allows a property owner to avoid paying capital gains tax on the sale of their property by investing the proceeds into a “like-kind” property within a specified time period.
While this process is relatively simple in broad terms, there are a few specific requirements that must be met in order to qualify for a 1031 exchange. Marzo Capital Group can help you navigate those requirements and ensure you qualify for this tax benefit.
Refer to “What is a 1031 Exchange?” to learn more.
Pros of a 1031 Exchange
There are many benefits to a 1031 exchange, and each one can have a notable and positive impact on your portfolio. We have outlined the primary benefits below.
Build Equity Long-Term
Using a 1031 exchange is likely a good option if your goal is to build a portfolio over the long-term. There are no limitations on the number of times you can use this tax advantage, so you can potentially defer paying capital gains tax indefinitely and keep all your equity within your portfolio. This makes it much easier to grow a portfolio, since you aren’t constantly writing a check for taxes every time you sell a property.
Diversify and Grow Your Portfolio
Another benefit of a 1031 exchange is that it makes it much easier to diversify and grow your portfolio. Because the process allows you to keep more of your equity in the property each time you sell, you have more capital to work with to buy more, better or larger properties.
One important aspect to note with a 1031 exchange is the “like-kind” requirement. Although some people assume this requirement means you must purchase a property exactly like the one you just sold to qualify, that is not the case. The “like-kind” requirement simply means you must invest in another form of real estate, including anything from a single-family home to a multi-story office building. This is a key benefit of a 1031 exchange that gives you the ability to significantly grow and diversify your portfolio over time.
The “like-kind” requirement also isn’t restricted to a specific geographic area. If you sell a property in one state and want to purchase a new property in another state, you are welcome to do so.
Doing a 1031 exchange also allows you to “trade up” to a higher-value property if you choose to do so, growing the value of your portfolio while still deferring any capital gains taxes.
Increase Benefits of Depreciation
As you may know, depreciation on your property can be written off for tax purposes to account for the natural deterioration and obsolescence of the property over time. This is a common practice for property owners and is a great tax benefit.
However, the downside of the depreciation deduction is that it eventually runs out. In a 1031 exchange, you might be able to reset the depreciable amount of your investment, which would give you a bigger tax benefit.
The tax implications of a 1031 exchange can vary, so we recommend consulting with an accountant or one of our experts to understand how it will impact your specific situation.
Heirs & Estate Planning
For investors who plan to leave assets to multiple heirs, it is possible to consider their financial situations when structuring your 1031 exchange.
As part of the exchange, investors may purchase multiple, or in some cases, an unlimited number of properties. setting the stage to leave different assets to different heirs.
We touch on these topics in greater detail in our articles titled A Solution for Your 1031 Exchange & 10 Advantages of Owning a Delaware Statutory Trust (DST).
Cons of a 1031 Exchange
While there are numerous benefits of 1031 exchanges, there are also a few potential drawbacks that you need to understand. Below are the drawbacks that you will be most likely to run into.
Strict Timing Guidelines
If you’ve done any research into 1031 exchanges before reading this article, you’ve probably seen that timing is everything. The Internal Revenue Code outlines a specific timeline that must be met for a 1031 exchange to be possible.
First, you must identify the property or properties you intend to purchase within 45 days of the sale.
Second, you must close on that property or properties within 180 days of the sale.
If either of those requirements are not met, the 1031 exchange will not be allowed and you will likely have to pay the taxes you were trying to avoid.
Not All Properties are Created Equal
Another potential drawback of a 1031 exchange is that all properties are not created equal. Although the “like-kind” requirement is relatively lenient, it’s still up to you to find a suitable replacement property that meets your requirements. You might be able to avoid taxes in the short term but purchasing a poorly performing property purely for the tax benefits will not be good for your portfolio in the long term.
This potential drawback is why it’s so important to have an experienced team on your side during the 1031 exchange process. A team of experts can do the legwork of finding a suitable replacement property for you, leaving you with ample time to consider your options and make an informed decision.
Potential to Still be Taxed
Lastly, there are some situations in a 1031 exchange where you could still be taxed on a portion of the proceeds. The most common situation occurs when there is another form of taxable gain during the transaction, either due to leftover equity not spent on the replacement property, a change in your loan liabilities or a tax on the accumulated depreciation.
For example, if you sold your previous property for $2 million, but your replacement property only costs $1 million, you will be taxed on the difference.
As with the potential depreciation benefits discussed previously, we recommend you speak with your accountant or one of our experts to better understand how this potential drawback could impact your specific situation.
We hope this article gave you a good overview of what a 1031 exchange is and what its pros and cons could mean for you. Although 1031 exchanges can be complicated, they are a powerful tool that every real estate investor should have in their toolkit.
If you are considering a 1031 exchange for your property or have additional questions about the process, don’t go it alone. Our experts at Marzo Capital Group have helped countless investors navigate the 1031 exchange process successfully and smoothly, and we would love to assist you as well.
To continue learning about whether a 1031 exchange is right for you, schedule a consultation with one of our experts today.
Or, to learn more about real estate investing and how a 1031 can complement your portfolio, visit our Learning Center.
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