Owners of investment property struggle with the dilemma of how to take advantage of built-up equity in their properties and increase their return on equity. An exchange may be the key to unlocking built-up equity and providing the opportunity to expand a portfolio and create greater wealth. A 1031 exchange is a transaction in which an investor exchanges (sells) investment property (to purchase better) investment property (commercial or residential property) and defers the payment of capital gain taxes, health care taxes, state taxes, as well as the recapture of depreciation taxes – all of which needs to be paid if you don’t do a 1031 exchange, that sale would create a taxable event. Deviating from the process outlined in a 1031 exchange may result in tax consequences or costly penalties.
Why Do an Exchange?
Selling and purchasing better replacement property can lead to:
- Greater Cash Flow (greater rent)
- Diversification (not putting all your equity in one property) and greater appreciation (appreciating in more than just one property)
- Upgrade or repositioning real estate holdings can create additional depreciation to help create additional tax write-offs to help you save more money on income taxes.
If you plan to use a 1031 exchange, understand that there are some pretty strict rules that MUST be followed. If you don’t, you won’t get the tax-deferred exchange. It’s as simple as that. So here are 5 to keep in mind:
- Properties Must Be “Like-Kind”
- The Replacement Property Should Be of Equal or Greater Value
- The 45-Day Identification Window
- The 180-Day Closing Window
- You may not touch the money of the relinquished property
The beauty of the 1031 exchange is the ability to repeat this process over and over again on properties and continue deferring taxes indefinitely. 1031 exchanges can be phenomenal wealth-builders by allowing you to transfer the property proceeds tax-free into a larger piece of real estate. This can help you build generational wealth.