A 1031 Exchange is a valuable tool to any investor dealing in real estate. As a taxpayer, if you sell a capital asset, whether personal or real property, and if there is a gain, tax must be paid on that gain in the year of the sale. If you are selling your property in the hopes of purchasing a new one, these taxes can take away from the amount you have to put towards the new property.
There is, however, another option for investors who are looking to move on from one investment property to another – a 1031 Exchange. Formally defined as a IRC Section 1031, this exchange provides an exception and allows the taxpayer to postpone paying the tax if the proceeds from the sale are reinvested in a similar property as part of a qualifying like-kind exchange. Gain deferred in an exchange is tax-deferred, but not tax free.
What is the Value of a 1031 Exchange?
The main value of a 1031 Exchange is it allows you to be able to defer capital gain taxes to a later time by exchanging two like-kind properties instead of a traditional sale and purchase transaction. A taxpayer can completely defer all proceeds into a new property or do a partial exchange and retain some of the proceeds, only paying taxes on the part retained. This is a huge advantage for investors as it can increase your cash flow and options for gaining a new investment property.
This is a great option for investors who have too much equity in their properties. Investors can also use the proceeds from the sale of their investment properties and put it towards multiple different properties, allowing you to diversify your holdings. Participating in an exchange instead of a sale will allow you as an investor to take the entire equity of your investment property and put it towards a new asset by deferring taxes on the original property.
Currently, the tax rates are as follows:
- Federal Capital Gain Tax – up to 20%
- Affordable Healthcare Surcharge – 3.8%
- Depreciation Recapture – 25% of depreciation taken
- State Tax Rate – varies by state
As you can see from these rates, deferring taxes through a 1031 Exchange equates to a large amount of savings. By utilizing a 1031 Exchange, you as an investor will be able to defer those taxes and put that cash towards your new investment property, saving you money both now and in the long run.
What are Some Reasons to Perform a 1031 Exchange?
While the value of a 1031 exchange stems from the ability to defer capital gain taxes, there are many other reasons why an investor would utilize this transaction. We’ve provided a list of three of the main reasons we see investors participate in a 1031 exchange.
- Estate Planning: If you are an investor looking to pass your assets on to your heirs, 1031 exchanges can be extremely beneficial for your situation. With an exchange, you can sell one investment and exchange it for multiple investments. This allows all your heirs to have an equal share investment without having to split one single property.
- Relief From Management: Some investors have to put a lot of work into their investment properties. From maintenance to finding tenants, some properties are just more hassle than they’re worth. Even if your property isn’t a headache, you may just be tired of running an investment property and are looking for a solution that is a little more hands-off. 1031 Exchanges will allow you to consolidate a portfolio or write off an exact amount of debt from a troublesome property. You will maximize your tax benefit and create a situation where you can get out of headache causing assets that are more trouble than they’re worth.
- Location Changes: Some investors prefer to be close to the location of their investment properties to be able to actively manage the property. So what happens when you have to change locations to a different area or state and want to remain close to your investment property? A 1031 exchange is the perfect solution in this instance. You can exchange your current property for one closer to your new location without taking a loss from the capital gain taxes you would have to pay on a traditional sale.
As you can see, 1031 Exchanges provide extensive value to investors in a variety of situations. While the main benefit to these exchanges is the deferment of capital gain taxes, they can be used in many different ways to ensure you are getting the most out of your investment.
If you want to learn more about 1031 Exchanges and the benefits they provide you as an investor, download our free Resource Guide!