Savvy Investors Use 1031 Exchanges to Build Wealth (2024)

FAQs

Savvy Investors Use 1031 Exchanges to Build Wealth? ›

A 1031 exchange can be used by savvy real estate investors as a tax-deferred strategy to build wealth. However, the many complex moving parts not only require understanding the rules, but also enlisting professional help—even for seasoned investors.

A 1031 exchange frees up more capital which means you can acquire a replacement property at a significantly higher value. By trading up for higher-value properties, you'll be able to build your wealth and hit investment goals quickly.

The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing more capital for investment in the replacement property.

Section 1031(f) provides that if a Taxpayer exchanges with a related party then the party who acquired the property in the exchange must hold it for 2 years or the exchange will be disallowed.

President Biden has released his proposed budget for 2024, which again looks to eliminate 1031 like-kind exchanges.

While Section 1031 is a legitimate tax strategy designed to encourage investment and economic growth, some critics argue that it contains a "loophole" that can be exploited to minimize tax liability.

The Deferred Sales Trust is an effective 1031 exchange alternative to help business and real estate owners sell their assets and defer capital gains tax. Both the 1031 exchange and Deferred Sales Trust are well-established investment strategies.

If you try to exchange very quickly after acquiring a property or go through many properties a year, the government may consider you a dealer and the properties would then be considered stock in-trade, and therefore, would not be eligible for the 1031 exchange rule.

How Does A 1031 Exchange Work? You can postpone paying capital gains taxes by selling a property and putting the proceeds toward a “like-kind” property, which is a property that is similar in nature and value. If you don't receive proceeds from the sale, there's no income to tax.

How soon after a 1031 exchange can you sell? ›

If a property has been acquired through a 1031 Exchange and is later converted into a primary residence, it is necessary to hold the property for no less than five years or the sale will be fully taxable.

Flips can be lucrative and create a reward of a quick profit. However with most flips, you will be paying taxes at ordinary income tax rates. If your intent is for business or investment and you meet certain criteria, then your property may qualify for 1031 treatment.

If you're able to fit everything within the required timeframe, there's nothing to prevent you from selling two or more properties as part of a 1031 exchange. It's a great opportunity to trade from multiple small real estate investments into a larger opportunity.

Converting after a 1031 Exchange

You must use the 1031 to purchase property you intend to use for investment purposes. However, you can convert a 1031 property into your primary residence after holding it for productive use in business or trade for a period of time.

When swapping your current investment property for another, you would typically be required to pay a significant amount of capital gain taxes. However, if this transaction qualifies as a 1031 exchange, you can defer these taxes indefinitely.

A 1031 exchange allows you to defer taxes, which is the main advantage of doing one. You're deferring capital gains tax after selling a property and picking up a "like-kind" better property that can potentially cash flow way more than the previously owned one.

There are several things to keep in mind about using a 1031 exchange for new construction, including: The new construction project must be equal to or greater than in value than the original investment property at the end of the construction and before the representative deeds it back to the original investor.

A vacation home, second home, or any other property used exclusively by the taxpayer for their own enjoyment, and which has no business or investment motive is not eligible for a 1031 exchange.

Reinvest all of your 1031 exchange proceeds, or net equity, from the relinquished property into the replacement property. Ensure the mortgage, or debt, on the replacement property is equal to or greater than that of the relinquished property to avoid debt relief.

A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like-kind and equal or greater value.