Is a 1031 Exchange Right for You?

Is a 1031 Exchange Right for You?

Whether you’re a seasoned real estate investor or just an individual that’s looking to sell your property, it’s important to understand your options. You might have heard the term 1031 exchange before. Understanding how 1031 exchanges work could be a game changer for your investment strategy. We’ll look into the high level ins and outs of 1031 exchanges, their benefits, drawbacks and how to determine if utilizing an exchange is right for your financial goals.

What is a 1031 Exchange?

For starters, it’s important to know the basics. Why is it called a “1031 exchange”? This name comes from section 1031 of the Internal Revenue Code (IRS) that allows real estate investors to defer paying capital gains and depreciation recapture tax when they swap one investment property for another investment property. Typically, when selling real estate you’d be subject to a whole host of taxes such as capital gains tax, depreciation recapture tax and net investment income tax.  This can eat away a large portion of the proceeds from the sale of your property. Section 1031 allows for you to reinvest your taxable gains into a new property, instead of selling and immediately owing taxes.

Section 1031 does come with it’s rules, such as needing to invest in “like kind” property. Meaning you can’t do a 1031 into a new personal residence. It’s important to note that when utilizing an exchange, you MUST utilize the services of a qualified intermediary to hold the proceeds from the sale of your investment property in escrow or your exchange will be void. It also involves strict timelines and rules. In order to complete your exchange, you must identify your replacement property within 45 days and close on those properties within 180 days. We have a calculator that you can use to determine your timeline at the link below!

https://www.fiduciary1031.com/resource/1031-exchange-date-calculator/

Benefits of a 1031 Exchange

The primary benefit of a 1031 exchange is tax deferral. Since you’re reinvesting the proceeds into a new property, you’ll be postponing paying capital gains taxes. This has multiple benefits including freeing up more capital for the investment. This is a strategy that many institutional investors use to significantly enhance their ability to build wealth over time. It can also provide flexibility and diversification in an investment portfolio by allowing investors to upgrade or move into different asset classes without immediate tax consequences.

If you continue to complete 1031 exchanges until you pass away, your heirs will receive a “step up in basis.” This will adjust the cost basis of an inherited asset to its fair market value. Since the heir is receiving a stepped up basis, they can now sell the asset and forgo capital gains taxes. This is a strategy called “swap till you drop,” which is essentially a great way to build generational wealth by never needing to pay capital gains taxes on a asset.

Potential Drawbacks of a 1031 Exchange

There are many benefits to completing a 1031 exchange, however, there can also be some potential drawbacks. 1031 exchanges come with very strict rules and deadlines that must be met. The process can also be complex and time-consuming. This is where our firm comes in, we help our clients navigate the complexities of 1031 exchanges to ensure that all requirements are being met.

Additionally, it’s important to remember that not all properties will qualify to be used in a 1031 exchange. If you’re looking to sell an investment property and purchase a new primary residence, for example, the 1031 exchange wouldn’t be the right fit you.

Who Should Consider a 1031 Exchange?

We see this strategy as being very beneficial for active real estate investors who have large gains and plan on continuing to re-invest. Whether you want active management or passive, there are many options available for each.

This can also be a great option for someone that’s looking to get out of the landlord business. If you’re selling an asset that requires a lot of active management, such as a rental home, we specialize helping our clients find more passive investments such as Delaware Statutory Trusts (DSTs) that are completely passive and usually pay income distributions monthly (we’ll discuss this more in a later post).

When Might a 1031 Exchange Not Be Right for You?

The 1031 exchange might NOT be the right fit if you’re needing a quick sale or need liquidity. It’s also not going to be the right fit if you’re looking to buy or sell a personal residence since they would not qualify as like kind.

In Summary

The 1031 Exchange is a powerful real estate investment tool for investors that are looking to defer taxes and accelerate wealth growth. However, it’s always important to consider the strict rules of completing an exchange and making sure that this strategy is in line with your investment goals and financial plans.

We’re here to help you navigate the complexities of the 1031 exchanges and discuss if it’s the right fit for you.