A 1031 exchange can be a great financial tool for real estate investors who want to grow their wealth from investment to investment without paying capital gains taxes or depreciation recapture taxes. You can sell an existing property and roll the entire equity amount into the purchase of a new property, so that you can keep all of the appreciation value of your real estate.
However, a 1031 exchange may or may not be right for your portfolio. It depends what your goals are.
If you want to continue building wealth by increasing the value of your real estate holdings, a 1031 exchange can help. If you need to cash out of an investment to gain access to capital, a 1031 exchange is not for you. And, because you have a time limit to complete the exchange, many investors feel like they can’t do their due diligence on a new property before buying it – and it can be all too easy to rush into a bad deal. Let’s discuss the pros and cons of 1031 exchanges, so you can decide if this type of deal is right for you.
Pro: You Can Defer Capital Gains Taxes
Perhaps the biggest benefit of a 1031 exchange is that you can use one to defer capital gains taxes on the purchase of a new piece of real property. Here are 1031 exchanges explained: you select a qualified intermediary to help you facilitate the exchange. You designate a property in your portfolio to be sold. The qualified intermediary takes the proceeds from the sale and holds them in trust for you. Within 45 days of selling your relinquished property, you must designate in writing a new property to be bought with the sale proceeds. You have 180 days from the time you closed on the sale of your last property to close on the sale of a new one. If you successfully execute a 1031 exchange, you can put all of the profit you made on your relinquished real estate holding into buying a new investment, without paying capital gains taxes.
Con: You Don’t Get Any Access to Your Capital
The problem with a 1031 exchange is that you don’t get any access to the capital you have tied up in your real estate. A common misconception is that you only have to roll the portion of your real estate proceeds that exceed your initial investment, but in fact, you have to roll both your initial investment and your profits into the new piece of real estate. If the new piece of real estate is worth less than the old one was and you get money back, that is considered the boot and you will have to pay taxes on it.
Pro: If You Die, You Never Have to Pay Capital Gains Taxes
You can literally keep doing 1031 exchanges over and over all your life, and if you die without cashing out that last property, you can thereby avoid ever paying capital gains taxes on your investment proceeds. Your heirs will inherit the property at its current market value, and they won’t have to pay capital gains taxes, either, unless they sell it without living in it for two out of the last five years.
Con: It Can Be Too Easy to Rush into a Bad Deal
Because you’re under a time limit to get the 1031 exchange done, it can be hard to do your market research and choose a property you really want to buy while feeling the pressure. Sellers know that you’re under a time crunch in a 1031 exchange, and may try to take advantage of the stress you might be feeling. You could end up buying a property you didn’t really want, buying without doing appropriate market research, or paying too much. If you want to do a 1031 exchange, it can be best to have a replacement property in mind before you start the transaction. You can even buy your replacement property first in a reverse 1031 exchange.
Pro: You Can Get Exposure in New Markets
You can perform a 1031 exchange with any two properties in the country, so if you want to quickly dump a property in a cooling market to take advantage of the potential for profits in a warming one, you can. You can sell a property in Alaska and use the proceeds to buy a property in Maine, or Florida, or California.
Con: 1031 Exchanges Are Complicated
Plenty of investors put off doing a 1031 exchange because they’re intimidated by how complicated it seems. And while it’s not that complicated when only one investor is involved, it can get infinitely more so when you’re trying to exchange a property you own with a group of other investors. If some owners want to perform the exchange and others want to liquidate or hold the property, you could run into trouble.
Are 1031 exchanges worth it? If you’re a real estate investor looking to grow wealth and avoid taxes, they very much can be.