Section 1031 exchange is a tax benefit that offers major advantages to real estate investors. This strategy not only helps investors to defer paying capital gains taxes but also scales, optimizes, and diversifies an investment portfolio and increases cash flow among others. This article by Lilypads focuses on the top 10 benefits of a 1031 exchange that investors must consider.
1031 Exchange in a nutshell
Investors can opt for 1031 exchanges or like-kind exchanges while selling their commercial property.
1031 tax-deferred exchanges help the investors to defer or postpone the capital gains tax liabilities by reinvesting the proceeds from the sale of the relinquished property in a like-kind property of equal or greater value.
Read Lilypads’ article on the rules of 1031 Exchanges here.
The pros and cons of a 1031 Exchange
Benefits of a 1031 exchange:
1. Opportunity to diversify and expand investment portfolio
One of the several advantages of 1031 exchanges is that investors can purchase diverse replacement properties.
Furthermore, a 1031 exchange diversifies a portfolio to generate more returns over time.
For instance, an investor can exchange a single-family investment property in an appreciating market for multiple rental properties in up-and-coming areas. Therefore, they can enter less volatile markets and earn better cash flow.
Besides, investors can also switch properties according to their desired level of involvement.
Therefore, a multifamily investor can swap their apartments having high tenant turnover for a single-family rental property as the exchanging property.
2. Ability to reset your depreciation:
The depreciation of a property is written off to compensate for its wear and tear.
Hence, the IRS allows 27.5 years as the depreciable period of an investment property.
So, investors can deduct the value of the building divided by 27.5 from your taxable income amount in each year of the first 27.5 years of owning an investment property.
But, assessors generally lack proper information on property improvements unless there is a sale. In such cases, the property is reassessed completely.
As a result, investors may only get the depreciation amount based on the initial value while buying.
However, with a 1031 exchange, the investors have the option to reset the depreciable amount of their investment property to a higher amount, which gives more yearly tax benefits.
3. One of the chief benefits of a 1031 Exchange is the exposure to new markets:
Through 1031 exchanges, an investor can capitalize on the biggest advantage of investment real estate- the diversification of risk.
Hence an investor can own fractional shares of different types of institutional assets across the US with no restrictions.
In traditional property exchange, such a degree of diversification would be difficult to achieve.
4. Trade up for higher-value properties:
By the means of a 1031 exchange, investors can trade up for one or more properties that better match their investment goals.
Moreover, these properties can generate higher returns, and investors also do not need to pay taxes on the new investment. Hence, the 1031 exchange enables investors to access higher-value properties for investment.
5. Build equity over time:
1031 exchanges offer a limitless number of exchanges. Therefore, an investor can enter the market with a modest investment and continue to trade up repeatedly. As a result, they can earn significant cash flow till their net worth increases.
Hence, these investors who have been deferring capital gains taxes can pass on those investments to their heirs.
Furthermore, these heirs can realize a step up in the cost basis of all these investments to the current fair market value. And, eventually, they can eliminate all tax burdens completely.
6. Provides management relief:
The investors who purchase several rental properties are often overburdened with intensive property management and costly maintenance.
But, with 1031 exchanges an investor can hire an on-site property manager and be a passive investor in the replacement property.
7. Increased income/cash flow is another one of the major benefits of a 1031 Exchange
In addition to these, 1031 exchanges increase both cash flow and overall income.
Furthermore, an investor who owns vacant land that does not generate any cash flow or depreciation can exchange it for a commercial asset.
A 1031 exchange helps an investor to move their investment to a different location for a variety of reasons that includes: retiring to another state, job relocation, a more favorable market, and local business incentives.
9. Estate Planning:
A real estate investor can keep eliminating capital gains taxes with 1031 exchanges over their entire life. Then, the heirs who inherit these investments receive their fair market value. Therefore, the accumulated gain on the replacement property goes away when the taxpayer passes away.
Moreover, 1031 exchanges help an investor to potentially sell and divide a large property into several smaller properties, for each heir. As a result, they can both minimize capital gains tax and plan the formation of an estate.
Thus, investors can remove any capital gains liability permanently with proper planning.
10. Leverage Up:
In a 1031 exchange, replacement real estate can be purchased using pre-tax dollars. So, the exchanger can purchase a replacement property with funds that they would have otherwise paid as capital gains tax on a sale of the property.
Therefore, the exchanger can potentially leverage such funds to substantially increase their purchasing power and build wealth.
Furthermore, more equity can lead to a lower loan-to-value ratio and approval for the acquisition of higher-value property. Thus, the 1031 exchange can be used as a long-term strategy and be combined with other tax strategies to build a portfolio.
The Lilypads Bottomline
A 1031 exchange is one of the smartest strategies in real estate investing. The benefits of the 1031 exchange are available to any taxpayer selling non-owner-occupied real estate, held for investment or productive use in a trade.
So, it is wise that investors gain insight into the benefits and risks of such strategies before undertaking them. Extra leverage, portfolio diversification, and increased cash flow make the 1031 exchange an excellent tool for investment.