A 1031 Exchange is a tax-deferral strategy that is available to commercial real estate owners. This strategy can offer significant advantages to real estate investors and is considered a valuable tool. However, it may come with a number of downsides. This makes you want to ask ‘is it worth doing a 1031 exchange?’
Is It Worth Doing a 1031 Exchange?
Yes, it is worth doing a 1031 exchange. Through a 1031 exchange, capital gains tax is deferred on equity transferred between real estate investments. Additionally, taxes on capital gains, which can be as high as 15% to 20% won’t be due upon sale. Advantages like these make 1031 exchanges one of the best methods for building wealth over time and diversifying your investment portfolio.
The 1031 exchange may have quite some factors that can make it somewhat technical, strenuous, and undesirable such as the strict timeline and process involved. However, these possible challenges do not outweigh the benefits that the 1031 exchange offers commercial real estate investors.
What Is a 1031 Exchange?
When you sell an investment property that has appreciated in value, you have to pay taxes on the capital gains you make at the time of sale. Depending on your income bracket, your tax will be about 15-20% at the federal level. In some states, you may also have to pay a state tax on capital gains.
A 1031 exchange, however, creates a twist to all of these. It allows you to defer the taxes on your capital gains until later on in the future. This means that, as an investor, you can keep more of your working capital, add more valuable properties to your portfolio and realize a higher cash flow compared to if you had to pay the taxes.
With this deferment strategy, there is no limit to how many times you can exchange your properties for more valuable properties as long as you follow all the rules laid down by the IRS. In theory, you could even keep increasing the value of your portfolio indefinitely by performing continuous exchanges.
Advantages of a 1031 Exchange
When utilized properly, the 1031 exchange is a process that is worth all the time, energy, and resources put into it. Here are some of the reasons why doing a 1031 exchange is worth it:
Deferral of Taxes
The primary advantage that the 1031 exchange offers investors is the opportunity to defer capital gain taxes till later in the future. With a 1031 exchange, you can sell an existing property, and acquire a more valuable one without having to pay income, depreciation recapture, or capital gain taxes.
These taxes can significantly eat into your revenue, especially with properties with a low-cost adjusted basis. Having them deferred can allow you to put the extra income into other necessary uses.
Ability to Grow and Diversify Your Portfolio
A 1031 exchange allows you to sell off an existing commercial property to acquire another property of “like-kind” properties provided it has a higher market value. This refers to investment real estate properties of similar nature within the United States excluding your primary residence. Only the commercial sector has access to this tool.
Since every property you acquire through this process would be more valuable than the last, there are unlimited possibilities for growing your portfolio. Your exchanges are not restricted to a specific state. This means you can choose to diversify your portfolio across markets with varying volatility across the country. This way, you are able to reduce your exposure to risks.
You can also exchange commercial real estate properties that require intensive management and extensive maintenance for properties that require minimal involvement. This way, you can relieve yourself of extra responsibility while getting a more valuable property with each exchange.
Access to More Valuable Properties
The essence of the 1031 exchange is the ability to freely exchange existing commercial properties for newer properties that are more valuable without being taxed on capital gains. This basically gives you easy access to commercial properties that guarantee you higher returns.
The 1031 exchange also gives you access to exchange your existing property for more valuable properties that may fit your investment goals better without having any significant tax implications.
Build Equity and a Strong Portfolio Over Time
The 1031 exchange is a useful wealth-building tool. Since there is no limit to the number of times investors can carry out a 1031 exchange, they can continually perform the process throughout their lifetime. This allows them to start with modest investments and build up more valuable investment assets till they have built an empire.
With the deferred taxes, they can significantly increase their cash flow and the value of their portfolio faster compared to investors who fail to leverage the 1031 exchange.
Disadvantages of a 1031 Exchange
While the 1031 exchange is a strategy that offers significant benefits for commercial real estate investors, there are some factors that you may have to consider. You should consider these disadvantages to determine whether a 1031 exchange is worth it. Here are some of the possible challenges you could encounter:
Stringent Rules
There are rules that have been established by the IRS to regulate the 1031 exchange process. If you duly follow these regulations and requirements, you can successfully defer your taxes till sometime later in the future when you choose to realize your capital gains.
However, if you do not strictly adhere to them, it could cost you a lot:
- Your tax status could be impacted and you will lose any favorable tax treatment you may be enjoying
- You could also incur certain penalties and you would still have to pay taxes on the capital gains from the failed exchange
Difficult Procedures and Tight Timeline
Given the nature of the rules and regulations of the IRS, it is not uncommon that a lot of commercial real estate investors encounter certain difficulties with the 1031 exchange procedures. One of the most common issues investors have is finding a replacement property within the given timeframe.
The IRS stipulates that you have 45 days after the sale of your property to find a replacement property. You then have another 135 days to close on that replacement property, making a total of 180 days from the sale of the existing property. Sadly, this timeline cannot be extended and if you do not meet up with the deadlines, you could face some punishments.
If you do not like working quickly, you might want to avoid the 1031 exchange entirely. Alternatively, it is best to work with an advisory company, like Si Vales Valeo Real Estate, to help you identify and structure your 1031 exchange to achieve success.
Reduced Basis on Replacement Properties
When you perform a 1031 exchange, the tax basis of the replacement property is reduced. During the exchange, the deferred capital gain on the replacement property is deducted from its purchase price. The 1031 exchange is a tax-deferral strategy and not a tax-free process.
Whenever you eventually decide to sell the replacement property, the IRS will fully recognize your tax liability and all the deferred gain that has accumulated will also be taxed.
Unpredictable Trends and Tax Rate Increase
With the 1031 exchange, you defer your losses on a property, just as you defer your taxes. This can be dangerous and risky when you choose to defer losses that could offset large profits in a fiscal year.
The government could have implemented higher capital gain tax rates that would mean more cost when you eventually decide to sell.
Taxable Boot
If you perform a 1031 exchange and get a property worth less than the relinquished property, you are left with the boot which is taxable. The boot is the difference between the value of the properties that are left in cash. This also applies to loans you take as leverage and they are also taxable by the IRS.
1031 exchanges can be very technical and problematic if not handled well. You should always have your 1031 exchanges handled by a team of commercial real estate investors like Si Vales Valeo Real Estate. We have vast experience in advising and handling these property transactions including 1031 exchanges. We are your best shot if you are looking to invest in the Cincinnati MSA.
Frequently Asked Questions
How Much Does a 1031 Exchange Cost?
It costs about $600 to $1200 on average to perform a 1031 exchange. The fees of the qualified intermediary usually account for most of these costs. This cost is for the regular 1031 exchange costs as other types of 1031 exchanges may come with other hidden costs
Can I Do a 1031 Exchange Myself?
No, you cannot perform a 1031 exchange by yourself. While you are in charge of how the exchange process is handled, the IRS specifies that the exchange should be handled by a qualified intermediary.
Conclusion
A 1031 exchange is an invaluable tool that commercial real estate investors can leverage to build wealth. However, the possible challenges make it technical. It is best for even seasoned investors to work with sound professionals with experience in handling 1031 exchanges, like Si Vales Valeo Real Estate.
