When most people think about a 1031 exchange, they just imagine the tax advantages they can gain from it. However, deferred taxes are not the only advantage from this type of exchange. Let’s take a closer look at some of them:
1. Tax Benefits
One of the premier benefits of investing in net lease are the tax benefits. Within the commercial real estate realm, the most common is the 1031 Exchange, with a Section 1033 Exchange close behind. Simply, these two mechanisms allow investors to defer taxes and build wealth over time. We’ll get into the weeds a bit later, but first, let’s be clear – tax-deferred exchanges can be extremely valuable as an investor. It’s wise and highly encouraged, that in taking advantage of these measures, you consult your account. Real estate can be complicated and having an expert set of eyes on the transaction is a smart move.
2. Defer Capital Gains
1031 exchanges, or 1033 exchanges, allow you to defer capital gains tax. Capital gains are generally taxed at a preferred rate in comparison to ordinary income and it provides incentives for investors to make capital investments and to fund entrepreneurial activity. Tax amounts depend upon your tax bracket and the amount of time your investment was held before you sold it. And doing a 1031 exchange is a popular choice for investors who have land that produces little or no income, or for those who find themselves with a management-intensive building who want to rid themselves of the extra hassles.
So how does this really work? When a property is sold and a profit earned (capital gains), the government wants its share (a capital gains tax). Through the application of a 1031 or 1033 exchange, an investor is allowed to sell one property and invest into another property without incurring the capital gains tax. You must however, invest all your profits into the next property (or properties) within a specific timeline.
1033 rules are different than those for a 1031. With a 1031, a qualified intermediary is required to hold the funds during the time between original sale and replacement acquisition, whereas in a 1033 exchange, the owners are allowed to hold the proceeds themselves. A 1033 also allows more time to “find” the replacement properties, being two years versus the 45 day period in a 1031 exchange.
The 1031 is again the most popular of the two exchanges and being a government program, there are specific rules and regulations that must be followed. The main rules, are that the property must be held for investment purposes and the exchange must be for “like-kind” assets. The replacement property must be identified within 45 days, with 180 days allowed for the transaction (or closing) to actually take place. All proceeds from the original sale must be turned over to the qualified intermediary, and the replacement property must be equal to or greater in value and equity.
Investors who opt for a 1031 exchange have the option of consolidating their properties. If they manage multiple properties and simply do not have the desire or time to do that anymore, they can exchange their properties for one big property. If they do not want to be responsible for managing the property, they can choose to purchase a property that has an on-site manager. Consolidating can take some of the stress off of investors’ backs and give them more time to participate in other business ventures.
4. Earn More Income
A 1031 exchange also gives investors the opportunity to earn more income. For example, let’s say an investor owns a property that is not generating a lot of revenue. He or she can exchange this property for real estate that has great earning potential, such as a commercial or residential property.
5. Opportunity to Diversify
Some investors are looking to diversify. They may want to increase their earning by investing in several types of real estate. A 1031 exchange allows investors to diversify by exchanging one property for multiple property types, like commercial and residential.
6. Increased Cash Flow for Reinvestment
If you are able to defer your taxes, you may have more money left over to invest in other properties. You have more purchasing power than if you sold a piece of property and had to pay all the taxes associated with it.
7. Exchange Out-of-State Property
A 1031 exchange is also beneficial for investors who have properties in more than one state. If they don’t want to continue to travel state to state to manage their properties, they have the option of exchanging their out-of-state real estate into property that’s in just one state. This can save them both time and money that it requires to travel to different states on a regular basis.
Of course, there are more details to know and rules to follow, but the basic premise of a 1031 exchange allows an investor to defer taxes, allowing an investor to build wealth. As an investor using a 1031 exchange, you must upgrade, buying a new and larger property, thus growing income and appreciation. There is no limit on the number of exchanges you can make, so a savvy investor can continue to use capital gains to acquire more revenue producing assets. As you look to minimize your involvement but continue to build wealth, you can see why single-tenant net lease (STNL) properties are ideal candidates for 1031 property exchanges.
Although there are many attractive benefits to a 1031 exchange, there are also some drawbacks to be aware of. It is important to take these drawbacks into consideration before opting for this exchange. For example, losses are deferred each year just like taxes. This means if you have a windfall profit year, you have to defer your losses instead of offsetting them for large profits.