Savvy investors have a number of tools in their arsenal they use to reach success. They don’t just stick to one thing. Instead, they diversify their options to reap greater rewards. Their methods are easy enough to follow if you have the inside track. For instance, one of the favorite strategies of successful investors is something called a 1031 Exchange. In short, this workaround gives investors the opportunity to exchange properties and defer their tax payments. But, there’s so much more to it than that. If you are interested in earning more about this concept, there’s no better time than the present. To this end, we provide this concise, but comprehensive, guide to help you along your journey of investment success:
What is a 1031 Exchange?
Paying capital gains tax is inevitable when selling your investment property. So, if you made unwise investments or are simply a victim of bad luck, selling your property can cost you more money than you make. On the other hand, if you own a rental property that’s worth significantly more now than when you originally purchased it, you can make a killing using the 1031 strategy. To do so effectively, you must exchange one property for another of similar value. By doing so, you defer your obligation to pay capital gains taxes as well. In short, a 1031 exchange is a tax deferral strategy for investors looking to achieve the following goals:
- Preserve equity: When structured properly, a 1031 exchange gives you the ability to defer 100% of your state and/or federal capital gain taxes and depreciation recapture taxes. In this way, it acts as an interest-free and term-free loan on taxes due until you sell your property.
- Leverage: This strategy is often used to exchange a property with a high equity position or one that is free and clear for a bigger and more valuable property. A bigger property usually gives a better ROI with increased cash flow and additional depreciation benefits.
- Diversification: Exchanges offer several opportunities for diversification. One of the most popular ways to diversify real estate is through geographic location. For instance, you could exchange a large multifamily property in Atlanta, GA for two multi-family replacement properties – one in Anderson, SC and the other in New Orleans, LA. Another diversification alternative revolves around a concept called asset class. In layman’s terms, you exchange several single-family residential properties for a small strip mall. That is, you exchange one type of property for another.
- Management relief: Experienced real estate investors usually acquire several properties throughout the years. The maintenance and management of such a portfolio can be time-consuming and frustrating, especially if the properties are not in the same region. If this sounds familiar, you will be happy to know that a 1031 can help reduce your maintenance and management responsibilities. Simply exchange several of your small properties for one large one.
- Estate planning: When a family member dies, his or her property is often gifted to several family members. Unfortunately, this can lead to disagreements. Some family members may want to keep the property while others may feel its best to sell it and pocket the cash. By conducting an exchange, from one big property to several small ones, each property can be gifted to a family member and the individual can decide what to do with their specific property.
It’s important to note that, although the 1031 helps you defer capital gains taxes, it doesn’t do so forever. You will eventually have to shell out some cash. But, in the meantime, this strategy lets you trade properties without worrying about your tax obligations. Secondly, as mentioned above, the property you exchange must be of similar value to the one you acquire. This seems pretty straightforward but, it can get a little tricky. For instance, if a seller has a $1 million property in Charlotte and a $750K loan, you would have to exchange it for a $1 million worth of property or $750K (or more) of leverage.
The Bottom Line
As you can imagine, there are several rules and qualification requirements that you must meet to perform a successful exchange. However, the deferral of the capital gains taxes makes the extra effort worth the hassle. Just remember to do your research so that you have an understanding of the real estate landscape in the area you are interested in. Good luck!