What Are the Advantages of a 1031 Exchange?
The main benefit of a 1031 Exchange is greater tax efficiency, which translates into more purchasing power and investor flexibility. Used correctly, this means higher returns, more cash flow, and even improved estate planning through the power of stepped-up basis transfers.
More Buying Power
The Federal government taxes 15-20% on capital gains (depending on your income).
Most state governments take an extra 3-10%. Rates climb as high as 13.3% for California investors (and this rate seems likely to rise in the near future).
Conservatively, that’s 25% to tax collectors and out of your pocket.
Here are the states with the highest gains taxes.
Capital Gains: The 20 Highest-Tax States
Remember: RE investors also face depreciation recapture taxes. These are normally 25%.
Since real estate tends to be quite pricey, the taxes due upon sale get very large, very quickly.
That’s a big drag for investors.
Put another way:
You can purchase more — and/or better — real estate with extra capital.
Consider 25% more buying power.
After every deal.
Savvy real estate investors frequently rely on 1031 exchanges.
Why?
Larger, more valuable properties generate (on average) higher returns.
After all, that’s what makes them more valuable.
Flexibility
A 2015 NAR survey revealed that like-kind exchanges give entrepreneurs extra flexibility, particularly when they can readily switch to properties with “better economic use”.
In other words, a 1031 lets you change:
→ Property type
→ Locations
→ Management responsibilities
All without paying taxes.
This means more efficient capital deployment.
That same NAR survey estimated 40% of all RE deals would not have occurred without a 1031 exchange.
And this makes complete sense.
Think about it:
Why switch to a new opportunity if doing so costs you tens (or hundreds) of thousands in taxes? Again, taxes are often your largest cost of sale.
Key takeaway: Choosing when to face a large tax bill can be a HUGE advantage.
Estate Planning
Here’s a cool thing:
The IRS built a backdoor in the Internal Revenue Code. And investors can use it to side-step capital gains taxes.
Completely.
(Not sure if they meant to. But it’s there)
What is it?
Stepped-Up Basis
It removes taxes on gains for assets inherited by your heirs, including:
- Real estate
- Qualified stocks
- Other capital assets
Our clients are often very happy to hear this. Particularly if they have kids!
The Tax Foundation explains this tax law:
Essentially, it boils down to one simple question.
Did your heirs inherit your property?
If yes, no capital gains tax carries over.
This leads to the expression — rather morbid — “Swap ‘til you drop.”
Here’s a simple breakdown of the strategy.
Fin.
Final Thought:
Talk with us about your broader investment strategy. Cover more than the upcoming transaction. What are your long-term plans? We can help you get there.
We hope you enjoyed the read.
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