What Are the Pros and Cons of A 1031 Exchange?
Investing in real estate has continued to be a great long-term investment strategy as it can offer equity creation through price appreciation and short-term cash flow that can come through rental or sale income. If you are going to invest in real estate, there will come a time when you need to sell it. If you do intend on selling real estate, you should consider doing so through a 1031 Exchange. A 1031 Exchange offers a variety of tax benefits to those that use it when selling the property, but there are drawbacks as well (1031 Gateway.com). It is important to consider the pros and cons of a 1031 Exchange if you are considering this option.
Pro – Tax Benefit
The primary benefit of a 1031 Exchange is that it can offer you very advantageous tax benefits. Without a 1031 Exchange, when you sell a real estate asset any money that you make on the sale of the property will be taxed at the capital gains rate. If you use a 1031 Exchange, you can defer this capital gains tax. This allows you to use all of the capital that is earned from the sale of a property to apply towards your next project.
Pro – Tax Liability Erased Upon Death
Another advantage of a 1031 Exchange is that the tax benefits you receive will be erased upon your death. While you are still alive, the total amount of tax benefits you receive will accumulate. If you were to sell, you would have to pay capital gains on the total net gains that you have. However, if you purchase and sell assets through a 1031 Exchange, the capital gains you have accumulated in the past will be erased from a tax perspective. Instead, your heirs will essentially inherit the properties at the current market value at the time of the death.
Con – Time Restrictions for New Purchase
One of the disadvantages of a 1031 Exchange is that you have time restrictions when it comes to purchasing your next property. Following a sale through a 1031 Exchange, you must be able to identify your next target investment within 45 days. You also only have 180 days to close on your next investment while rolling in your equity from the prior sale. If you do not complete both of these tasks on time, you will be taxed at the normal rate.
Con – Depreciation Benefit Does Not Increase with Market Value
Being able to claim property depreciation is a tax advantage that all real estate investors will take advantage of. Usually, the basis of the depreciation that you can claim is the purchase price of your property. However, when you continue to buy and sell properties through a 1031 Exchange, the depreciation basis will be the purchase price of the new asset less the gain on sale of the prior asset. This effectively will increase annual taxable income as your depreciation expense will be less.