Entering a 1031 exchange is a smart strategic move for investors, allowing them to defer capital gains payments and keep more of their equity working for them. However, there are long-term implications of continuing 1031 exchange cycles — both good and bad. A proactive investor like yourself should understand these possibilities to better prepare for them in the future.
Below, Realized 1031 has shared an article outlining these long-term implications to help you get started.
1. Tax Is Deferred, Not Eliminated
As you likely know, the primary use of a 1031 exchange is to defer capital gains taxes. In other words, you delay tax liability until a triggering event. Swapping a like-kind property for another does help you preserve your wealth temporarily, but the tax liability is actually never truly eliminated while you’re living. Capital gains taxes accumulate as you continue exchanging and will become due once you sell the final 1013 exchange property in a traditional sale. This growing amount can be significant once you finally decide to cash out.
2. Depreciation Recapture
Similar to capital gains taxes, depreciation recapture is also deferred when conducting 1031 exchanges. This value is the amount the IRS takes back if you sell a depreciated property at a profit.
Depreciation recapture is taxed at ordinary income rates, which means it can take away a significant chunk of your earnings if you decide to end the 1031 exchange.
3. Liquidity Limitations and Reduced Flexibility
1031 exchanges keep your capital tied up in real estate, which can limit your liquidity and investment diversification. While this can be a strategic move for long-term appreciation and cash flow, 1031 exchanges may make it harder to adjust your portfolio quickly in response to market changes or personal financial needs.
In addition, to complete an exchange successfully, you must adhere to strict IRS timelines and identification rules. These requirements can create pressure to reinvest quickly, sometimes leading to less-than-ideal purchases.
4. Opportunities and Risks in Estate Planning
On a more positive note, 1031 exchanges are eligible for a step-up in basis upon your passing. This benefit eliminates all capital gains and depreciation recapture by resetting the cost basis to the fair market value upon your death. Thanks to this process, your heirs won’t inherit the accumulated tax burden.
Even so, waiting for the step-up in basis adds to your liquidity issues. Your health and lifestyle needs may change later in life, and maintaining ownership limits your access to funds that can help you live a more comfortable retirement.
Long-Term Like-Kind Exchange Planning and Strategies
Managing the implications and taking advantage of long-term 1031 exchange opportunities requires you to be strategic and proactive.
- Consulting with tax and legal advisors is a must to help you understand the intricacies of these laws and processes.
- We also recommend thinking ahead of time regarding exit strategies. There are still other options you can try aside from a traditional sale, such as installment sales, partial exchanges, and charitable remainder trusts.
- If you plan to pass properties to heirs, consider trusts, LLC structures, or other vehicles to simplify the process and protect your family’s interests.
Wrapping Up: Long-Term 1031 Exchange Considerations
While 1031 exchanges offer tax deferral now, the long-term implications must be considered well before you enter this transaction. Knowing these possibilities, both the good and the bad, can help you better prepare and avoid significant tax hits at an age when you should be enjoying your hard-earned money.
Sources:
https://www.investopedia.com/terms/s/stepupinbasis.asp
https://www.investopedia.com/terms/d/depreciationrecapture.asp
https://turbotax.intuit.com/tax-tips/investments-and-taxes/1031-exchange-how-it-works/c998pvsTp
