The Top 5 Reasons to Do a 1031 Exchange
Imagine if you could invest in real estate and avoid paying capital gains taxes. That would be a sweet deal, right? The fact is that you can do just that by using the 1031 Exchange.
The 1031 Exchange is named for Section 1031 of the United States Internal Revenue Code. As a savvy real estate investor, you can take advantage of the 1031 Exchange to defer paying taxes on your profit when you sell an investment property. And that’s not all.
The 1031 Exchange can put more money in your pocket to invest, it can help you accumulate wealth and give you the opportunity to minimize your risk as an investor through diversification. To qualify, the property must be held for investment or business purposes.
Before we go into the main advantages of the 1031 Exchange, let’s take a look at the rules you need know to qualify.
What is the 1031 Exchange?
The 1031 Exchange has encouraged real estate investors to reinvest their profits for almost a century. According to the 1031 Exchange rule, your capital gains tax is deferred if you replace the investment property you sell with another “like-kind” property. Capital gains tax can range from 0% to a whopping 35% for combined state and federal tax, so by using the 1031 Exchange you can save a substantial amount of money.
It is important to note that primary residences do not qualify for the 1031 Exchange.
So how do you qualify for the 1031 Exchange?
Rules for the 1031 Exchange
As an investor, you have to meet strict rules to be eligible for the 1031 Exchange. The name appearing on the title of the property sold must be the same as the name of the property you buy. The rules state that you have to identify the replacement property within 45 days after the closing of the first property, and you will have to complete the exchange in 180 days.
To avoid paying tax when you sell your investment property at a profit, the market value of the property you buy must be valued the same or more than the property you sell.
You must reinvest the proceeds of the sale of your investment property in a like-kind property held in the United States. The term like-kind in a 1031 Exchange is very broad. For example, you can’t exchange farming equipment for an apartment building, but you can exchange a condo rental for a single-family rental.
Advantages of a 1031 Exchange
1. Deferred Capital Gains Tax
Deferring your capital gains tax when you sell an investment property at a profit is a major advantage of the 1031 Exchange. To defer all of your capital gains tax, the like-kind replacement investment property you buy has to have a price that is equal to or greater than the investment property you sold. If the replacement property is priced lower, you will have to pay tax on the difference.
2. More Money to Invest
When you use the 1031 Exchange, you will have more capital to invest in your replacement property. Saving on tax means that you will have greater leverage to buy quality property that can yield outstanding proceeds.
Using the 1031 Exchange can mean that you may be able to make a purchase that coincides with your investment goal – and you pay no capital gains tax until you sell. You may be able to tap into thriving real estate markets that were previously out of reach.
3. Accumulate More Wealth
The 1031 Exchange can allow you to accumulate more wealth, since there are no restrictions on how many times you can use the rule. You use pretax dollars to purchase replacement real estate properties, and you can build your portfolio by repeating the strategy indefinitely. By using the process numerous times you can increase your net worth and boost your cash income – all while paying zero tax.
4. Lower Depreciation Recapture
As an investor, you want to minimize your tax liability and maximize your profits. One way the 1031 Exchange can help is with lower depreciation recapture.
You can take write-offs for depreciation on your investment property for wear and tear. The IRS will want part of the money you saved back – depreciation recapture – when you sell your investment property. The 1031 Exchange can help you minimize the cost of depreciation recapture.
5. Diversification
You have probably heard the phrase “don’t put all your eggs in one basket.” In real estate that means it is a good idea to diversify your holdings by market, or by asset type. If you own property in a single market or of the same type, you may be faced with more risk.
The savings you have in a 1031 Exchange can help you diversify your investment portfolio over different markets or property types to reduce potential risk.
Getting Real Estate Investment Benefits with the 1031 Exchange
Using the 1031 Exchange when you invest in real estate can put you in a very good position to build wealth, diversify your portfolio and minimize your risk. The bottom line is that you can save a lot of money when you sell your investment property with the right advice and support. Kelli Ide, with Michael DeRosa Exchange, can help you make smart decisions about buying and financing your investment property.
Kelli Ide offers a unique, concierge-style approach to real estate, including staging, photo styling and market preparation services exclusively for clients to give them an edge over the competition. For further information about buying or selling a home, visit kelliide.com.
