PROS AND CONS
As with any type of investment, 1031 exchanges are not one-size-fits-all. Each individual investor needs to decide whether this type of arrangement makes sense for them. Here are some of the benefits as well as drawbacks associated with this type of real estate transaction:
The main reason that investors consider the 1031 exchange is the potential to defer capital gains taxes for as long as possible for as long as they reinvest the proceeds of any sale into another investment property.
In addition to the tax savings, compared to other investment vehicles the ability to reinvest the money that you’d otherwise lose to capital gains tax means there is potential for more cash flow from those original investment proceeds. For example, if an investment property of $1,000,000 was sold and the capital gains tax due was $400,000, this means the investor would have $600,000 remaining and might choose to put it into the stock market. With a 5% return each year that would provide $20,000 annually. However, if the original investment property was exchanged for another investment property with the same 5% return as the stock market might afford, the difference is that this investor would have a larger portion of the original investment amount to put in so that 5% would represent an amount much greater at $50,000.
The possibility of asset accumulation in which more or larger properties are acquired during each subsequent 1031 exchange is another benefit of this arrangement. From an estate planning point of view, this may be beneficial to those inheriting the investment property as the deferred taxes may instead be assessed with a STEP-UP in basis allowing the new owner to be assessed at current rates rather than the deferred rates.
In order for a 1031 exchange to be valid, there are many strict regulations that must be followed. Finding a replacement property within the 45-day requirement, as well as being able to close the transaction within 180 days are challenging to orchestrate and are critical to ensuring that the tax deferment status remains in place. In addition, it is important to remember that the capital gains taxes are deferred, and it means that eventually they will be due so some future planning will need to be done in order to properly deal with this event. In terms of the 1031 exchange impact on an investment property, it may reduce the depreciation amount that can be claimed on the replacement property since it will be based on the relinquished property’s adjusted basis.
With so many moving pieces to take care of for these intricate transactions, the requirement of working with a qualified intermediary should help provide the guidance and insight necessary to determine if this transaction is right for an investor.