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1031 Exchanges: A Smart Strategy for Real Estate Investors

1031 Exchanges: A Smart Strategy for Real Estate Investors

June 12, 2023

Considering a 1031 Exchange? At Scafa Financial Services, LLC, we know the world of real estate investing can be complex and confusing, especially when it comes to tax strategies. Our team can help you understand tax-deferral strategies and investment vehicles in order to potentially keep more of what you earn. 

1031 Exchange Investors

Section 1031 of the Internal Revenue Code is an effective strategy to defer capital gains tax that can rise from the sale of an investment real estate property. The 1031 exchange allows an owner of eligible property to complete a tax-free exchange by purchasing “like-kind” replacement property with the property sales proceeds. Such a transaction potentially allows deferral of up to 100% of the capital gains taxes otherwise due on the property sale. The IRS defines “like-kind” as any property owned for business or investment purposes.

This includes raw land, farmland, residential, rental and commercial properties. IRS Section 1031 does not apply to the exchange of stocks or bonds. This can be a powerful tool for building and preserving your wealth and as an estate planning strategy. It's key to work with a qualified financial professional who can guide you through the process and help you maximize the benefits of this strategy. 

It’s important to note that there are risks associated with this strategy like illiquidity and cost associated through fees.

  • You are required to reinvest all proceeds earned from the sale of the property if you want to defer the entire gain.
  • You are required to only invest in “like-kind” real estate assets.
  • You must work with a qualified intermediary to facilitate the exchange for you.
  • You must not take possession of funds at closing to have this qualify as a “like-kind” exchange.  
  • You have 45 days to identify potential replacement properties.
  • You have 180 days from the sale date of the original property to reinvest your funds.

Key Benefits of a 1031 Exchange 

Tax Deferral: A 1031 exchange is the ability to defer the payment of capital gains tax you would incur on the sale of an investment property. Instead of paying tax on the sale of your property, you can reinvest the proceeds in a new property and defer paying tax until you sell that property.

Gains created by the sale of property are typically taxable at both federal and state levels. The following taxes may be deferred through a 1031 exchange:

  • Federal capital gains – Up to 20%
  • State taxes – As high as 13%, in some states
  • Depreciation recapture – 25% of utilized depreciation
  • Net income tax – 3.8%

Deferred Depreciation Recapture: “Depreciation recapture” refers to the Internal Revenue Service's (IRS) policy that an individual cannot claim a depreciation deduction for an asset (thereby reducing their income tax) and then sell it for a profit without “repaying the IRS” through income tax on that profit. 

Increased Buying Power: By deferring the tax, you can potentially have more money to invest in a new property, which can increase your buying power as a real estate investor.

Portfolio Diversification: A 1031 exchange allows you to diversify your real estate portfolio with the possibility of shrinking your tax bill. For example, an investor can sell a single-family rental property and use the proceeds to purchase a multi-unit apartment building. In order for property to qualify for a “like-kind” exchange, it must be an investment property and not personal property, such as a personal residence.

Estate Planning: A 1031 exchange can be a powerful tool for estate planning, allowing investors to transfer assets to their heirs with a step-up in basis, potentially reducing or eliminating capital gains taxes to their heirs.

No Limitations on Number of Exchanges: There is no limit to the number of times an investor can use a 1031 exchange aimed at deferring tax on the sale of a property, as long as the exchange meets the rules and requirements set forth by Section 1031 from the Internal Revenue Service.

Trading In an Older Policy

A 1035 exchange, provided certain requirements are met, gives policy or contract holders the flexibility to "trade-in" an older contract or policy for a newer contract or policy. A newer policy or contract may have lower costs, a higher death benefit or more investment choices.

Partial Exchanges

Also, individuals can do a partial 1031 exchange for a portion of the total contract. A tax professional should be consulted for a partial exchange because any gain may be subject to ordinary income tax when withdrawn.

It's important to note that a 1031 exchange can be complex, and investors should consult with a qualified tax professional and real estate attorney before entering into an exchange.

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