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There’s a lot of hype all over the place about 1031 exchanges; I’ve heard them touted on just about every real estate radio show and website I’ve come across. Everyone’s talking about these 1031 exchanges as if they’re some magical cure-all to the capital gains tax. They’re not.
The 1031 Exchange
For those of you not familiar with a 1031 exchange, here’s how it works. If you bought an investment property 10 years ago and decide to sell it today, you can opt to do a 1031 exchange if you’re interested in purchasing another investment property. Normally, you’d have to pay capital gains tax on the profits of the sale, but a 1031 exchange allows you to defer capital gains tax if you use the proceeds to purchase another investment property of equal or greater value. You can keep buying and selling investment properties until your heart’s content, as long as you follow all the little rules required in a 1031 exchange, and not pay capital gains tax…at least not for a while, and this is what none of these real estate professionals seem to understand (or care to tell you).
If and when you finally decide you’ve had enough, you’re old, ready to retire and want to sell your investment property to give yourself a little more cash to spend on your orthopedic back pillows, you will have to pay capital gains tax on all of the profits from the sale. What does this mean? Ultimately, you’re still going to pay all the capital gains tax you would have paid had you not utilized a 1031 exchange. So what’s the benefit of the 1031 exchange? I mean, if the IRS will get your money anyway, why does the 1031 exchange even exist?
What’s Great About A 1031 Exchange
Well, now that I’ve made the 1031 exchange cry, I can answer that question. A 1031 exchange allows your money to grow tax-free; instead of the proceeds of a sale being taxed and then put into another investment property, a 1031 exchange will allow you to put all proceeds of a sale into the purchase of another investment property. So, when you decide to finally sell for that last time, not buy another investment property, and keep the proceeds, you’ll have to pay capital gains tax on all of your capital gains, but your actual gains will have been larger because they weren’t eaten away by taxes each time you sold. You see? So the 1031 exchange isn’t all it’s cracked up to be, but it’s still an important investment management tool that you should certainly take advantage of.
Note: 1031 Exchanges require some planning and really good time management. A lot of little rules go along with these things (God forbid the IRS could make things simple for us, right?), so if you plan to take advantage of a 1031 exchange, be sure to consult a tax accountant and real estate professional before you take any action; otherwise you may find that you’re no longer eligible for a 1031 exchange.
Update - 8/31/2007
One aspect of a 1031 exchange that I left out was brought to my attention today by one of my readers: William Exeter of Exeter 1031 Exchange Services, LLC. You can read more about 1031 Exchanges at The Exeter Discussion Board. Thanks for the input William!
As William puts it, you can “Swap until you drop,” for the purpose of generating positive cash flow in retirement and never outright sell the property and keep the profit. The idea is that, when you purchase an investment property, depending on your local market, you may have little to no positive cash flow. However, if you can hold that property for some time until it appreciates, you can use a 1031 exchange to “upgrade” into a higher priced property that commands higher rent, and thus, generate positive cash flow. You can repeat this process until, and if, you become satisfied with the amount of positive cash flow you’re generating.
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