A 1031 exchange is a tax-deferred exchange of one investment property for another. The IRS permits investors to sell an investment property and defer capital gains, provided they reinvest the proceeds into a replacement property. If you are currently investing in real estate, this probably seems intriguing. In determining if a 1031 exchange is right for you, consider the following pros and cons:
- Deferring Taxes
Many investors are surprised to learn that federal capital gains tax is not the only tax liability they must face when selling real estate. There are also state capital gains taxes (in some states), depreciation recapture taxes, and possibly Affordable Care Act surtaxes. Depending on a variety of factors, including the state in which your property is located, you could be facing taxes in excess of 35percent of your profits! But a 1031 exchange allows you to defer these taxes indefinitely—provided you reinvest your capital back into real estate.
- Potentially Higher Annual Cash Flow
Assume for a minute that you were able to net $2 million in cash from the sale of a rental home that had been owned and depreciated for 10 years and that the capital gains taxes due were $950,000 (sounds crazy, but a very real possibility if you live in California. If you were to pay the capital gains taxes and invest the remaining $1,050,000 in the market earning 5% on your money, you would be looking at annual cash flow of about $52,500.
But what if you were able to invest the entire $2 million to buy another real estate asset generating a 5% return (we’ll ignore the use of debt which would increase your returns further). You’d now be looking at annual cash flow of $100,000.
- Asset Accumulation
A 1031 exchange is a powerful wealth-building tool. There are no limits on the number of subsequent exchanges, allowing an investor to exchange into progressively larger properties over time. With proper estate planning, you can leave assets to your heirs, who may receive a “step-up in basis” of that asset to its current market value, effectively allowing your heirs to then sell the asset at its fair market value without paying the capital gains taxes.
- Property Management Relief
If your current property is management-intensive, a 1031 exchange could allow you to exchange it for one with less day-to-day management responsibility. One option to consider is a net-leased (NNN) property where the tenant is responsible for all maintenance and operating expenses. Another option is to exchange into a Replacement Property Interest™ in one or more high-quality, professionally managed properties. (See our Guidebook on this topic for more information)
- Strict Regulations
There are many rules and regulations to follow when completing a 1031 exchange, and you may find some difficulty when trying to comply. For example, you must identify one or more potential replacement properties within 45 days after the sale of your relinquished property. Then, you must purchase a replacement property within 180 days of the sale of the original property. Additionally, the replacement property must have a purchase price and and mortgage balance equal to or greater than the relinquished property being sold.
There are many more regulations to follow, and if done incorrectly, you could have to pay taxes or even penalties. Fortunately, an experienced Qualified Intermediary can help guide you along this process. See our post on “How to Choose a Qualified Intermediary” for more information.
- Reduced Basis for Depreciation
In a 1031 exchange, the amount of depreciation that can be claimed on a replacement property is based upon the adjusted basis of the relinquished property at the time of the exchange. This means that the amount of depreciation you can claim on your replacement property will generally be lower than if you had acquired the replacement property without use of a 1031 exchange.
- Not Tax Free
It is important to note that this exchange is tax deferred, not tax free. This means that if or when you ultimately sell your replacement property, without another exchange, you will be responsible for paying taxes on all of the capital gains and depreciation recapture you have deferred through prior exchanges. However, as mentioned above, this is potentially avoided through careful estate planning.