For real estate investors looking to sell and buy new properties, one process they should be familiar with is the 1031 exchange. The term 1031 exchange gets its name from the Internal Revenue Code (IRC). While there are many benefits of 1031 exchange, understanding how it works is the first step to reaping its rewards. Here is what you need to know.
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What is a 1031 Exchange?
Section 1031 of the Internal Revenue Code allows investors to avoid paying capital gains taxes when they sell and reinvest the earnings of the sale into a property or multiple properties of like kind and equal or greater value. By reinvesting, investors will defer the capital gains tax from the sale.
For example, an investor purchases a property in 2015 for $200,000, then by 2020, the property appreciated to $500,000 and the investor decides to sell. The sale will have a capital gain tax of $300,000 and the tax will need to be paid on that gain. However, if the investor decides instead to utilize a 1031 exchange, they can invest the $300,000 they earned into another property and defer the capital gains tax on that sale.
Benefits of 1031 Exchange: Why Should Investors Use it?
While a 1031 exchange may look like a tax loophole, it is a perfectly legal process that allows investors the opportunity to reinvest, build their portfolios, and more. Here are 5 benefits of 1031 exchange transactions:
Reset Depreciation
When declaring taxes from rental income, investors can claim depreciation as an expense toward their deductions. Typically, when selling your rental property, you would have to calculate its depreciation and pay the taxes associated. With a 1031 exchange, the depreciation is carried over into the replacement property and is deferred until the new property is sold.
Increase Cash Flow and Free up Capital
Between tax savings and building wealth through capital appreciation, owning property that produces positive cash flow will grow your assets quickly. You can leverage your assets to get a more expensive replacement property by using your proceeds of the exchange toward a down payment or even consider exchanging for a commercial or rental property to earn a monthly income.
Utilizing a 1031 exchange allows investors to avoid capital gains tax by reinvesting the money earned from the sale.
Diversify Portfolio
By purchasing properties through a 1031 exchange, you can diversify your portfolio by branching out into different markets or types of properties. Owning a single asset or several of the same type exposes you to more risk in the event that the market crashes.
Consolidate Properties
On the other hand, for some investors, owning multiple properties can be costly and time-consuming, especially if the ROI isn’t high enough. Investors can utilize the 1031 exchange to swap these properties for something that is less maintenance and easier to manage.
Transfer Assets and Profits to Beneficiaries Tax-Free
In the event of death, the property and profits associated will be transferred to the designated beneficiaries tax-free.
Millennial Title Protects Your Investment
As your partner, Millennial Title recognizes the importance of profitable investment strategies. At Millennial Title, we understand every aspect of real estate investing as well as its potential risks and rewards. From completing your title work and issuing policies, the team at Millennial Title is here to ensure your investments remain protected now and in the future. To learn more about title and escrow services, contact us today.
