Cash on hand is key when buying and selling real estate. The 1031 Exchange is a legislative clause that allows real estate investors to defer their capital gains tax liability when buying and selling properties by exchanging one investment property for another.
As long as a property is being held for an investment or to be used in a trade or business, it can be exchanged for another property that serves the same purpose. Real estate investors can build wealth by postponing tax payments owed.
What is the 1031 Exchange?
The Internal Revenue Code section 1031 or 1031 Exchange allows for the deferral of taxes when one real estate property is sold in conjunction with the purchase of another property that serves a similar function.
The Internal Revenue Service has a broad definition of how investors can meet the definition of properties being alike or in kind. Typically, any property held for business or investment purposes may qualify. Properties used for personal use do not qualify.
While the range of potential eligible properties for a 1031 Exchange is broad, the deadlines are not. The IRS requires investors to declare that they will perform a 1031 Exchange before they close the sale on their property. Investors can meet this requirement by opening an Exchange with a Qualified Intermediary and identifying a replacement property within 45 days of selling the original property.
The Benefits of a 1031 Exchange
Here are 5 ways to build wealth with a 1031 Exchange:
Defer Capital Gains Taxes
The primary purpose of the 1031 exchange is to allow real estate investors to defer capital gains taxes when selling an investment property as long as they buy another property at the same time.
By deferring capital gains taxes, investors can reinvest the entire proceeds from the sale of their property into a new property, maximizing their buying power.
In 2024, the federal long-term capital gains tax rate is 15% for investors filing separately with an annual income between $47,026 and $518,900 and 20% for investors with an annual income above $518,901. The capital gains from the property sale are included when calculating annual income.
Most states also collect a capital gains tax or apply their ordinary income tax to the capital gains realized, along with accumulated depreciation value.
Theoretically, investors can defer paying capital gains taxes over a lifetime of buying and selling properties. Each transaction enables investors to take advantage of the capital gains from their investments while paying minimal or no tax on the stepped-up cost basis.
The IRS does not limit the number of times real estate investors are permitted to take advantage of the 1031 Exchange. Capital gains taxes are paid when the investor realizes the gain, meaning they have sold a property and not purchased a replacement one.
Increase Buying Power
When investors are permitted to defer paying their capital gains taxes, they can leverage their property’s appreciation in value to increase their buying power. With more buying power, investors can purchase higher-quality assets for their businesses, expand their portfolios, diversify their investments to reduce risk, and explore new investment options in more desirable, albeit more expensive, markets.
Diversify Holdings
By using the 1031 Exchange when buying and selling properties, investors can purchase any real estate for investment or business purposes. The broad definition used by the IRS to determine whether a property is like or in kind means that investors can choose to exchange across property categories, including multi-family properties, office, retail, and industrial properties, along with geographic locations and asset classes.
When investors can diversify their holdings, they increase their potential to spread risks across investments and increase overall returns. By exchanging properties with the ability to defer capital gains taxes, investors can sell properties that no longer align with their investment goals and replace them with better choices.
Improve Cash Flow
Depending on their needs, investors may choose investments that improve cash flow by decreasing property maintenance or moving to a more desirable location. Investment properties are frequently a large part of an investor’s estate plan, so maximizing tax benefits and increasing utility commonly translate to more income now and more wealth passed on to the next generation.
Depending on their goals and how investors or heirs will use these properties, investors may choose to exchange properties in more desirable locations, ones with a greater ability to generate income, or properties that require less upkeep and time to maintain.
As investors prepare to pass properties on to heirs, they may also choose to sell multiple properties and consolidate their holdings in a larger or more desirable location. By consolidating holdings, investors can increase cash flow and reduce management costs.
Help with Estate Planning
Investors can use the 1051 Exchange benefit to purchase higher-value properties and diversify their investments, resulting in a high-value, balanced portfolio that can be passed on to heirs.
By strategically investing, estate planners can generate income for themselves while accumulating property for their heirs and maximizing the wealth they can pass on to the next generation.
What type of investment strategy is most similar to a 1031 tax-deferred exchange?
A 1031 tax-deferred exchange is most similar to investments in Qualified Opportunity Zones. Investors buying property using the 1031 exchange have a wide range of options as long as they buy properties for investment or business purposes. Investors can also defer taxes on capital gains by buying property in a Qualified Opportunity zone, but they are limited to purchasing properties in economically distressed areas.
There is no specific holding period associated with using a 1031 Exchange, but taking advantage of investments in a qualified opportunity zone requires holding properties for at least 10 years to maximize tax benefits.
Whether you use 1031 Exchanges or Qualified Opportunity Zone benefits, talk with your estate planning attorney and financial advisor to learn more about the specific rules that may apply In your circumstance and how you can optimize your potential tax benefits.
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