Section 1031 of the Internal Revenue Code allows investors to sell property, reinvest funds in new property, and defer capital gains taxes. Known as 1031 exchanges, this type of transaction is fairly common among savvy investors who know the advantages and disadvantages of them. Here are some 1031 exchange property pros and cons you should be aware of before becoming involved in one.
The biggest advantage to a 1031 exchange is tax deferment. When you sell investment property and then immediately reinvest those funds, you can put off paying capital gains taxes until a later date. By deferring taxes, you then have more money available for reinvestment. The extra purchasing power allows you to continue growing your investments and building personal wealth.
There are also a few other advantages, including:
- Being able to eliminate older properties in favor of a newer, more desirable one
- Reducing or eliminating costs associated with property management
- Eliminating the need for extensive renovations in order to upgrade property
The IRS has very stringent rules when it comes to 1031 exchanges, all of which must be followed in order to qualify. As such, keeping up with the rules and regulations can sometimes be a nightmare. Should you fail to follow regulations, you could be subject to significant tax penalties that would offset any savings you had realized.
One of the biggest hurdles you’ll face is the requirement to find a replacement property within 45 days of your sale. The IRS does not offer an extension of this time, which is why you should have a reinvestment property in mind before finalizing the sale on your existing one.
You’ll also have a lower basis on your newly-acquired property. For tax purposes, the basis is the purchase price minus the gain that was deferred on the relinquished property. Losses are also deferred, which could prove detrimental if you earn a significant profit and have nothing to offset it with.
The pros and cons of 1031 exchanges should be weighed carefully before deciding if they are right for you. For more information, contact us.