1031 Exchange Pros & Cons

In the world of real estate, Section 1031 of the Internal Revenue Code plays a crucial role in facilitating transactions that can lead to success. However, there are both benefits and drawbacks to utilizing 1031 exchanges. To learn more about these, read on. Life Bridge Capital, a top real estate syndication firm, provides investment partners with the chance to convert shares of multifamily rental properties into a passive monthly income. Discover more about our offerings by visiting our website.

What is a 1031 Exchange?

Generally, selling real property leads to a tax liability for the year in which the property is sold. This means that selling an investment property results in a substantial tax payment ranging from 15% to 20% of the capital gains. However, a 1031 exchange provides an opportunity for investors to defer these taxes by using the proceeds from the sale to purchase a new property of a similar nature.

The Internal Revenue Code provides specific guidelines regarding 1031 exchanges, which investors must follow to benefit from the tax deferral.

The Internal Revenue Code states that real property held for productive use in a trade or business or for investment can be exchanged for real property of like kind without recognizing any gain or loss. The funds from the sale of the previous property are used to purchase the new property during a 1031 exchange. “Like” does not mean identical in this context, so investors can use this strategy to upgrade properties while deferring taxes.

Pros of 1031 Exchanges

1031 exchanges play a crucial role in building and expanding wealth by allowing investors to defer taxes and retain more funds for future investments. The benefits of a successful exchange are numerous and can include:

Maximize Cash for Leveraging

Complying with Section 1031 not only ensures a transaction’s legality but also opens up the potential for future leveraging and exponential earning. For instance, selling a property for a $200,000 profit and deferring $30,000 in capital gains taxes can translate to $150,000 in buying power for the next project, assuming an 80% loan-to-value ratio. With each transaction, the capital gains increase, and the money deferred also increases. It’s worth noting that Section 1031 allows for multiple property exchanges rather than just one.

Unlimited Deferments

To further defer capital gains taxes, investors can continually repeat the 1031 exchange process by selling an investment property and using the funds to purchase a new property of like-kind. This cycle has no limit on the number of times it can be repeated, allowing investors to continue deferring taxes and building wealth.

Taxes Erased Upon Death

Once the investor has completed unlimited 1031 exchanges, and tax deferments, the property can be passed on to heirs upon the investor’s death. Inheriting the property provides a stepped-up basis for the heirs, which adjusts the value of the property for the higher market value at the time of inheritance. This readjustment effectively erases any deferred capital gains taxes accumulated by the investor through their 1031 exchanges prior to their passing.

Cons of 1031 Exchanges

While there are few downsides to a 1031 exchange, it’s important to take note of them. One major drawback is the difficulty of finding and purchasing a qualified replacement property or properties. The regulations surrounding Section 1031 are complex, and failing to comply with them can result in hefty penalties. Overall, while 1031 exchanges have their benefits, it’s important to carefully consider the potential downsides before proceeding.

Exchange Restrictions

One of the most challenging aspects of a 1031 exchange is the strict timeline for identifying replacement properties and completing the exchange. Investors are limited to identifying up to three potential properties within 45 days of selling their previous property, and they must purchase one of those properties within 180 days. It’s important to note that the IRS does not often grant extensions, and failing to meet either deadline will result in a failed exchange. In this case, the investor will be required to pay the full tax bill on the capital gains from their previous property.

Future Tax Bill

Investors who are considering a 1031 exchange need to understand that while the exchange can defer capital gains tax, it does not eliminate it entirely. If the exchange does not take place, the deferral ends with the sale of the replacement property, and the investor will owe the full tax bill on the capital gains.

It’s important to keep in mind that the capital gains tax rate may change, and it’s not possible to predict whether it will increase or decrease. Therefore, when considering the potential tax bill, it’s important to factor in the uncertainty of the tax rate. While a decrease in the tax rate would be a welcome surprise, an increase would mean a higher tax bill.

Final Thoughts

When executed with careful planning, 1031 exchanges have the potential to make a significant difference in an investor’s wealth. A successful exchange can provide substantial tax savings, and multiple exchanges over time can contribute to the building of a real estate portfolio. If you’re interested in passive monthly income through real estate investment, consider partnering with OnBridge Capital, a top real estate syndication company. Visit our website to learn more.