There are many ways to grow wealth via real estate investing, but few tactics are as effective at maximizing profits as the 1031 exchange. This tax-deferral mechanism is named after Section 1031 of the US Internal Revenue Code. It spares you from paying capital gains taxes upfront when you sell a property and reinvest the money in a new, comparable property.
In addition to being a prudent approach to expanding your investment portfolio, this method provides substantial tax benefits. In the long term, these advantages might safeguard and grow your money. Gaining maximum benefit from a 1031 exchange might expand your investment strategy’s potential.
What is a 1031 Exchange?
Known by many as a “like-kind exchange,” a 1031 exchange enables investors to postpone paying capital gains taxes. In general, you have to pay taxes on the gain when you sell a property for a profit.
On the sale of real estate, the capital gains tax is either 0%, 15%, or 20%, depending on your income and filing method. As noted by CNBC, the capital gains tax is calculated based on whether you are filing it as a single or jointly with your partner.
For instance, a single filer pays a 0% tax rate on capital gains of up to $47,025. However, when filing jointly, the 0% tax rate slab applies to couples with gains of up to $94,050 in a financial year.
Similarly, for single filers earning between $47,026 and $518,900 and joint filers between $94,051 and $583,750, the tax rate is 15%. The highest capital gains tax rate is 20%, applicable on single filers and joint filers earning more than $518,901 and $583,751, respectively.
According to RealtyMogul, you can delay this tax liability by using a 1031 exchange to roll over the proceeds into a new property. You can use this method repeatedly to let your real estate assets compound and increase over time without worrying about paying capital gains taxes.
“Like-kind” describes the kind of item that is being traded. The properties must both be eligible as investment or business-related assets, but they don’t have to be of the same kind or worth. For instance, if both are investment buildings, you may trade in a rental apartment building for a strip mall or office building.
How frequently may I utilize a 1031 exchange?
The number of times you may use a 1031 exchange is unlimited. If the substitute properties satisfy the other conditions and are like-kind, you can keep deferring taxes by employing this technique. That’s how you accumulate wealth by deferring taxes while continuing to invest in like-kind properties.
Key Benefits of a 1031 Exchange
As stated above, the biggest benefit of a 1031 exchange is the opportunity to postpone paying capital gains taxes. You can reinvest all your earnings from the sale of a property to avoid paying taxes on it, enabling your capital to grow. This may significantly increase your spending power and a speedier process for increasing your investment size.
One way to diversify your real estate assets is through a 1031 exchange. The exchange enables you to make property-related changes without incurring tax losses, such as:
- Switching to a larger investment
- Entering a new market
- Switching property kinds
If you’re moving from a highly appreciated property in a hot market to a more stable, cash-flowing one, this can be really helpful.
Another key benefit is the increased cash flow in terms of rents. As shown in a NerdWallet article, rent prices have gone up by 33.6% since the pandemic. The average rent across the US is $2,063 in August 2024, a 0.2% increase from July 2024. In fact, median houses spend close to 30% of their income on rent.
With 1031 exchanges, some properties provide more potential for cash flow or rental income than others as your investment portfolio increases. You may increase your total returns by switching out underperforming properties for ones with better revenue potential through property exchanges.
Is it possible to keep some cash and trade property for one worth less?
Yes, this is a “partial exchange,” but you must pay capital gains tax, or “boot,” on any money you keep after the sale. The value of the replacement property must match or exceed the sold property’s value in order to fully postpone taxes.
Rules and Deadlines to Keep in Mind
In order to get the most out of a 1031 exchange, you must follow the strict rules and timeframes set out by the IRS. The exchange might be nullified and void, and the sale of the property would be immediately taxable if certain guidelines are broken.
As stated by Thomson Reuters, the property you are purchasing and selling must be held for investment or commercial use. Primary houses and other properties used for personal purposes are not eligible. Regardless of whether it has been updated or not, a property is deemed like-kind if it shares the same characteristics and personality as another. When deciding whether a piece of property is like-kind, the IRS does not take its grade or quality into account.
You have forty-five days after selling your house to find suitable replacements. You may mention up to three properties, regardless of their value, or more properties, provided that the specific value requirements are satisfied. These must be explicitly specified.
You have 180 days from the time you sell the first property to the time you close on the replacement. The 45-day and 180-day periods are concurrent; therefore, waiting to identify replacement properties will not extend the 180-day term.
Can I use the money from the sale to upgrade the replacement property?
Yes, this type of transaction is known as a “build-to-suit” or “improvement exchange.” As long as all modifications are finished within the 180-day period, you are able to utilize the sale profits to upgrade the replacement property.
You may maximize your real estate assets with a 1031 exchange by expanding your portfolio, reducing taxes, and improving cash flow. With careful planning and an awareness of the regulations, you may use this tax deferral method to accumulate wealth over the long term. Whether planning an estate in the future, diversifying assets, or renovating properties, a 1031 exchange can help you get closer to your financial objectives.
