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The Pros and Cons of a 1031 Deferred Exchange

If you’re interested in real estate investing, you need to know about 1031 exchanges. Why? This type of transaction can help scale and optimize your portfolio when executed strategically and under the right circumstances.

But before you decide to “1031 exchange that,” it’s important to educate yourself on what’s involved — and set yourself up for success with the right partners and gameplan. Below, we’ll walk through the basics of 1031 exchanges, their pros and cons, and how Roofstock can help make the process simple.

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First things first: What’s a 1031 Exchange?

When you sell an investment property, you’ll pay some hefty capital gains taxes at the time of the sale if you have gains. These taxes will surface at the federal level. The amount will vary based on your income, but in most cases you’re looking at around 15%-20% for federal taxes on capital gains.

Depending on where you live, gain could also be taxed as income or gain at the state level. Further, accumulated depreciation recapture hangs around till the last mile and is taxed at a federal rate of 25%, with varying results at the state level. It would be advisable to get in touch with your CPA for a translation. (In some cases, capital gains taxes can go up to 28 percent).

Related: Common misconceptions about 1031 exchanges

However, you won’t owe any taxes at the time of sale if you execute your 1031 deferred exchange sufficiently.

Also known as a “like-kind” exchange, a 1031 deferred exchange allows you to defer all capital gains taxes if you reinvest the proceeds in a new property or portfolio of properties of equal or higher value and maintain similar or higher loan amounts. There are other things that need to be considered, but these are the two big ones.

There are no limits on how many times or how frequently you can do a 1031 deferred exchange.

As long as you hold your properties long enough and don’t trigger “dealer status” with the IRS (typically a two-year hold or longer), there are no limits on how many times or how frequently you can do a 1031 deferred exchange. Theoretically, you could do it forever — selling properties and then reinvesting in like-kind properties, deferring taxes and building greater equity and value over time.

Did you know? You have to hire a Qualified Intermediary (QI) to facilitate 1031 tax-deferred exchanges. Nationwide, the average cost of a QI is around $1,250. Roofstock can get you connected with the right QI. 

When it comes time for inheritance, your loved ones can also benefit from a basis adjustment that effectively has the potential to eliminate the gains-related taxes forever. That’s why many real estate investors utilize this strategy for ballooning their real estate investment returns and bustle their estate.

Pros of a 1031 exchange

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Beyond the obvious plus of deferring capital gains taxes, there are a number of other reasons why 1031 exchanges are an attractive option for property investors. Here are a six key benefits:

#1: Opportunity to invest in a portfolio

“Like-kind” doesn’t necessarily mean a house for a house. It just means the new investment has to be investment real estate. The recent changes in tax law eliminated all exchange types except for real estate. This means real estate investors win. Some of the most astute real estate investors have 1031 exchanged a single-family home in a highly appreciated market such as California in order to purchase a portfolio of rental properties in a lower volatility/more affordable state with better cash flow, which can generate greater returns over time.

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#2: Ability to elect to reset your depreciation

As a property owner, you can write off “depreciation” of your asset to compensate for deterioration related to the wear and tear, aging or other structural obsolescence of the home. For example, the IRS recognizes 27.5 years as the depreciable time period for an investment property (your CPA can describe other acceptable methods). This means that every year, the amount of the value of your “improvements” (the value of the building) divided by 27.5 can be deducted from ordinary taxable income for 27.5 years. Translation: You have the potential to reduce the amount of income taxes you pay because of depreciation.

However, overall appreciation is typically realized in the value of the land and not the property. This is because assessors typically don’t have information on improvements made to the property unless there is a sale. So while your property may have increased in value based on structural improvements, you may only be able to achieve a similar benefit of depreciation as when you initially bought the property.

Related: Tax deductions for rental property owners

In a 1031 deferred exchange, your CPA may elect to reset the depreciable amount of your investment property to a higher value that would give you a bigger tax benefit. Again, see your CPA for a translation.

#3: Exposure to new markets

Want to invest in a market with growing potential? Like-kind exchanges aren’t constrained within state lines. This means you can capitalize on one of real estate’s best advantages, which is the diversification of risk. Getting your foot in the door of an up-and-coming market early could lead to bigger returns down the road.

Related: 3 questions to ask about investment property locations

#4: Trade up for higher-value properties

A 1031 deferred exchange lets you trade up to a property or portfolio of properties with higher returns or qualities that better match your investing goals — and you won’t have to pay tax on the new investment until you sell (unless you choose to do another 1031 exchange). For example, one Roofstock customer was able to double his investment property cash flow by doing a 1031 exchange from a single commercial property into a large portfolio of single-family rental homes (case study coming soon!).

#5: Greater exit flexibility

Single-family homes can be traded in smaller amounts, which provides flexibility and freedom.

Purchasing a portfolio of single family rental properties gives you the flexibility to sell portions of your assets over time, on your time. One of the great things about single-family rental properties is the ability to accessorize. Commercial real estate typically trades in one big lump, which can create liquidity constraints. Single-family homes can be traded in smaller amounts, which provides flexibility and freedom.

#6: Build equity over time

There’s no cap on how many times you can do a 1031 exchange. That means you could turn a duplex into a fourplex into a single-family rental portfolio into a real estate empire.

Cons of a 1031 exchange

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While 1031 exchanges can be a fruitful strategy, there are a couple of challenges to be aware of before you start the process. 

#1 There’s a tight timeline

There are very strict timeline requirements when it comes to 1031 exchanges. You have 45 days to identify which property(s) you plan to buy, and you must close on that property(s) within 180 days. So if you’re not prepared to make things happen quickly, a 1031 exchange may not be the best option.

#2 Finding “like-kind” properties can be difficult

In order to do a 1031 exchange, you must first identify which property(s) you’d like to invest the money in. However, it can be very challenging to find “like-kind” replacement properties that fit the bill, especially within the time constraints of 1031 exchanges. Keep in mind, gains deferred in a 1031 exchange are tax-deferred, but not tax-free. Have the right plan and resources in place. You don’t want to scramble and end up with a subpar property that doesn’t fit your long-term investment goals just to avoid taxes. Or worse yet, you could have to pay taxes on the entire gain.

Tip: Roofstock’s robust marketplace of leased single-family rental properties makes it easy to purchase and own customized portfolios of turnkey, cash flowing homes within 1031 exchange time limits. Browse their inventory of stabilized, certified properties that are ready to buy with the click of a button, and transact 100% online with ease.

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#3 You’re taxed on “boot"

If you have any cash left from the sale after you close, the Qualified Intermediary will pay it back to you. However, that money (referred to as “boot”) is taxed as capital gains. Additionally, as we mentioned earlier in this article, accumulated depreciation recapture hangs around till the last mile and is taxed at a federal rate of 25%, with varying results at the state level.

If you used leverage, you also need take your loans into account, both on the property you’re selling and the new one(s) you’re purchasing. If your liability is going down, it will be treated and taxed just like cash boot.

Say, for example, you had a mortgage of $1M on the old property, but a mortgage of just $800K on the exchange property. You’d be taxed on that $200K gain.

How Roofstock helps with 1031 exchanges

As the leading marketplace for buying and selling investment properties, Roofstock helps you easily identify quality replacement investment properties for your 1031 exchange — whether it’s a couple properties to help fill the boot or a turnkey portfolio of 25 rental investment homes.

Roofstock takes the guesswork out of the equation by gathering all of the due diligence and providing it up front for every listing. You can review full inspection reports, tenant payment history, key return metrics, neighborhood insights and tons of other helpful data points about the property. Roofstock even sets you up with trusted lending providers, local property managers and the right Qualified Intermediary, taking the guesswork out of finding reputable partners.

Many of Roofstock's rental investment properties for sale already have tenants in them, which means you’ll start collecting rental income right after you close.

Once you’ve decided to make an offer, all you have to do is add it to your cart and it’ll be taken off the site so no one else can snatch it up. All of this makes that 45 day window to identify a like-kind property way less stressful.

A 1031 exchange is one of the savviest strategies in real estate investing. If you’re interested in pursuing one, schedule a consultation to receive guidance on their tools and services designed to aid you in identifying the right portfolio size to match your needs.

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About the author
Ted Farry is the President of Conatus Real Estate that is focused on aligning investors with small multifamily and single-family rentals nationwide. Over a 5-year period, Ted purchased over 1,000 single-family rental properties for high net worth individuals as part of a family office in Newport Beach, CA. Conatus Real Estate has also partnered with Roofstock to provide a host of solutions to 1031 investors.
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