If you have an investment property, you might’ve encountered the term “1031 Exchange.” If you’re wondering what that is, who it’s for, and when to use it, look no further! We’ll also explain the upside and potential pitfalls.
What is a 1031 Exchange?
A 1031 exchange is named after IRS code section 1031 and it allows an investor to sell a property and defer capital gains when reinvesting those sale proceeds into a similar like-kind property.
A seller may decide to sell and purchase a new property for several reasons – they may wish to invest in a different, more lucrative market, or perhaps the existing asset is undesirable due to needing extensive repairs. Many real estate investors will purchase rentals in cities they enjoy visiting – those visits may be tax deductions when conducting business, like checking in on that property or visiting a property manager. Or, they may wish to diversify the types of properties in their portfolio, or expand their portfolio by leveraging the sale of one property to purchase two.
1031 Exchange: The Benefits
The first (and probably most obvious) benefit is the deferred taxes on that capital gains income from selling a property. You’re able to sell one property and use those proceeds to purchase another similar property that offers more benefits or better returns, while putting off the tax consequences.
Second, a 1031 Exchange may offer the opportunity for increased cash flow. Think in terms of trading up. You might sell one property for another in an up-and-coming market, or a property that commands higher rents.
The third benefit is your ability to manipulate your portfolio. You might decide to diversify, selling two properties and buying a higher-end, more expensive property, or expand you portfolio by selling one and leverage the proceeds to purchase two more.
1031 Exchange: The Potential Pitfalls
1031 Exchanges sound good, but they may not be for everyone.
First, this financial vehicle operates on very strict timelines. The IRS is very clear about defining the time that you’ve got to identify your replacement property (or properties), and the time to close (complete the transaction) on that property.
Next, 1031 Exchanges aren’t DIY. Per IRS rules, you cannot handle, hold, or exchange proceeds, not even an uncashed check. You need a Qualified Intermediary, the professional that will take your proceeds from the sale, hold them, and then be responsible for ensuring that they properly roll over into the new property. Working with the Intermediary cuts out all kinds of costly, time-consuming, and frustrating problems. And, as a rule of thumb, a 1031 cannot be structured after you receive proceeds from a sale.
Finally, a common pitfall to avoid is not accounting for the expenses involved – for example, hiring that Qualified Intermediary. There are also exchange fees, and just like other conventional real estate purchases there are fees associated with your agent’s services, title insurance, escrow, and appraisal fees.
Talk with your CPA to find out if a 1031 makes sense for you – if you’re a retiree in a low tax bracket, for example, a 1031 may not be necessary. And, if you’re taking a loss on selling one investment to invest in another, a 1031 would not make sense, so be sure to talk with a Desert Dimensions licensed Arizona Realtor before making any decisions.
Resources (links do not constitute endorsements):
When to Open a 1031 Exchange (and When Not to)
Common 1031 Exchange Mistakes to Avoid