A 1031 Exchange Does a Lot More
Than Defer Taxes
Sure, everyone wants to reduce their tax liability and Section 1031 of the Internal Revenue Code allows you to defer the gain on the sale and subsequent acquisition of “like-kind” property held for business use or investment. Exchanges are much like a typical sale followed by a purchase but they are linked together by paperwork and completed within certain timeframes. A 1031 exchange allows you to defer the gain as long as the replacement property is held and if you eventually sell that, assuming it still qualifies, you can 1031 exchange again. While the deferral of the gain is the most commonly thought of benefit of Section 1031, it is all of the opportunities that this tax deferral opens up that are the most important benefits of exchanging.
Following are just some of the numerous benefits of exchanging:
- Time Value of the Deferral: A 1031 exchange gives you the opportunity to acquire replacement property using pre-tax dollars.
- Levering the Deferred Gain: The deferred gain can be leveraged into a significantly higher priced replacement property that will likely generate additional cash flow from Day 1 and enjoy greater long-term appreciation.
- Defers Depreciation Recapture: A 1031 exchange defers the capital gain (or a loss) as well as the depreciation recapture which is usually recaptured at 25% on real estate.
- Minimize Income Tax Paid: As the deferred gain does not increase a taxpayer’s income, it could keep you out of the highest income tax bracket and capital gain rates as well as helping you avoid the new 3.8% Medicare Tax, AMT, personal exemption phase outs and the Pease limitations.
- Buyer’s Advantage: Many times, a Buyer using 1031 exchange funds is preferred because they have money waiting an account and they want to close quickly.
- Reduce Management Responsibilities: Exchangers can opt to acquire replacement property that is a more passive investment, such a Triple Net Lease (NNN) property, Delaware Statutory Trust (DST) or Oil & Gas Royalties. These assets allow you to use your time in other ways while maintaining the cash flow you want.
- Increase your Cash Flow: Many Exchangers use 1031 exchange to trade up and into a property that will have a higher cash flow than the relinquished property. Some common examples include trading a single-family rental property for a multi-unit or trading a rental at the Jersey Shore for one closer to the ocean where you can charge higher rents.
- Relocation or Expansion of Business: A business owner can relocate to a better location, more efficient facility or expand into multiple locations using Section 1031.
- Acquisition of New Business Assets: Exchanges allow business owners to replace older equipment with new equipment (which may be eligible for bonus depreciation). Any business assets can be exchanged for other like-kind property, including franchise agreements, aircraft, distribution rights and livestock. This often leads to hire revenue and increased workforce.
- Future Conversion to Personal Use Property: Whether you are planning for retirement or simply cannot afford to acquire a vacation home yet, a 1031 exchange may be able to help. The eventual sale of the replacement property may qualify for the Section 121 Primary Residence Exclusion or a Vacation Home 1031 Exchange.
- Possible Elimination of Gain: When exchanging, the gain is deferred as long as the replacement property is owned. When eventually selling the replacement property, the gain can be recognized or if the property qualifies, exchanged again. The gain can be deferred indefinitely and when one passes away, his heirs inherit the property with a stepped up basis and the gain is forgiven. Of course, you want to minimize any applicable estate taxes but the first $5M is exempt from for individuals.
When selling a business use or investment asset, consider what your short and long-term goals are and whether or not a 1031 tax-deferred exchange can help you accomplish them. More often than not, an exchange can be the first step.