The pros and cons of the 1031 tax deferred exchanges
The 1031 exchange, popularly known as a tax-deferred exchange, is a common and straightforward strategy that offers significant advantages to the commercial property owners. To qualify for this section, the property exchanges must be held for the productive use in business, trade or for the investment purpose. Thanks to IRC 1031 exchange, the real estate investors may sell certain qualified property and reinvest the proceeds from that property and can acquire the replacement property as per certain time limitations and other regulations.
What is section 1031?
1031 exchanges are also known as “like-kind exchanges” that allow investors to defer paying capital gains tax on the sale of property by reinvesting the proceeds into the new property. This kind of exchange allows investors to preserve the gross equity earned from the real estate property investment that increases their buying power. Further, there are no limits on how many times or how frequently you can do the 1031 exchange. And, do you know, you have to hire a qualified intermediary to facilitate the 1031 tax-deferred exchanges.
- Leverage and increased cash flow for investment: By deferring taxes, you will have now more money to invest further. This increased purchasing power will give you an extra leverage to acquire. For example, a property or many properties with higher investment benefits is a better option than if you sold the actual property and paid all the taxes associated with the sale and purchase of the new property.
- Exposure to new markets: Want to invest in the market with a growing potential? Yes! Like-kind exchanges are not limited to the state lines. This means, you can capitalize on one of the real estate’s best advantages.
- Trade-up for the higher value properties: A 1031 deferred exchange lets the investors trade up to a property or the portfolio of properties with higher returns which better match your investment goals and you need not to pay the taxes on the new investment.
- Helps you to get relief from management of property: If you own a property or several numbers of properties burdened with excessive maintenance costs and require management, then you may exchange and replace that property for others with less responsibility.
- Wealth and asset accumulation: 1031 exchanges are actually a great wealth building tool. Commercial property investors who continually perform the 1031 exchanges may benefit from the cash flow and net worth increases. In actual, one could exchange into numerous properties over the years in their lives and pass those to their kids.
These were some of the amazing benefits with the 1031 exchanges. Apart from this, there are some cons of these exchanges including:
- Multiple rules and regulations to follow: The IRS has established several regulations in the 1031 exchange according to the competing interests of collecting taxes and rewarding taxpayers for investing back. If these regulations are fully complied with, then no income will be recognized at the time of commercial property exchange. And, not strictly adhering to these rules and regulations may doom your tax status and in fact you could incur penalties.
- Losses cannot be recognized: Just as the applicable taxes are deferred, losses are also deferred. In any windfall profit year, for instance, the deferring losses which could have offset the larger profits could be a painful decision. So, one must always carefully weigh the benefits of such deferrals.
- Its only tax deferred not tax-free: Remember that 1031 exchanges are the tax deferred transactions which are not tax-free. If you decide to sell, your tax liability will be fully recognized.