Section 1031 of the Internal Revenue Code contains arguably one of the most powerful provisions of the tax code for real estate investors... the 1031 tax exchange. Many highly successful real estate investors have used this tax code provision in combination with aggressive pyramiding and upgrading strategies to amass huge investment property portfolios. Here's how it works:
OVERVIEW
A Section 1031 Exchange allows you to exchange "like-kind" investment properties without triggering the payment of capital gains tax. As your property assets appreciate in value you have the ability to upgrade into larger properties with greater cash flow. Section 1031 also gives you the flexibility to exchange your rental properties that have appreciated in value in hot markets, and re-invest into lesser-known areas that are expected to develop and become the next hot market in years to come. You can continuously defer these capital gains taxes as you continue to pyramid your property investment portfolio into larger and larger properties.
1031 EXCHANGE BENEFITS
There are a lot of benefits to considering the use of a 1031 exchange:
TAX DEFERRED INVESTING
The ability to re-invest your entire property equity without tax erosion can significantly enhance the amount of capital that stays invested and can make it easier to upgrade into higher value properties with greater cash flow.
INCREASE CASH FLOW
This decision to upgrade into higher quality properties with greater cash flow can occur faster now that taxes are a lower priority transaction decision. In some markets the real estate values can get ahead of the available cash flow available from the property. In these situations it may make sense to lock in your gain and look to re-invest in another property where you can achieve higher cash flow returns.
TIMING THE MARKET
The ability to speculate on the next hot market area or region is a much easier decision under a 1031 exchange. Why not lock in your profits on property that has already risen dramatically in value and re-invest it in the next hot market? As long as your capital gains are deferred making these transaction decisions is easier.
COMPOUND RETURNS
If you are stepping up your portfolio through a series of exchanges over time your full capital gain can be re-invested without tax consequence, resulting in accelerated equity accumulation.
FLEXIBILITY
The ability to switch into "like-kind" properties as defined in the tax code gives you a range of investment options and flexibility. If you don't want a lot of the headaches associated with managing property you can also consider Tenant in Common exchanges, which do qualify under Section 1031 of the tax code.
CONCLUSION
1031 tax exchanges gives real estate investors a lot more options and flexibility to make better investment decisions on their real estate holdings without the issue of tax over-riding sound judgment. If you own a rental property or are considering it you owe it to yourself to see if a 1031 exchange is right for your circumstances.
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