One of the benefits of real estate ownership is the ability to defer payment of capital gains tax on the sale of a property. This deferment is accomplished through a 1031 exchange or a Starker exchange.
Last week, I attended a seminar on 1031 exchanges. The speaker listed 4 main reasons why real estate investors take advantage of the 1031 exchange.
Currently the federal capital gains tax is 15% or 20% based on your income. California’s top capital gains rate is 13.3%. At the top tax rate a real estate investor in California could be paying almost 33% of their gain in taxes. An investor’s ability to build long-term wealth is hampered if they need to pay taxes on each transaction.
Buy “More” Property
A 1o31 exchange allows the investor to buy bigger or better property. An investor might decide to exchange into a property that is larger in price or they may decide to go into property that increases their cash flow.
Diversification is the theory of spreading investment across multiple assets in order to reduce risk. Your grandma might say, “Don’t put all your eggs in one basket.”
Geographic Diversification. Having real estate investments in different locations and metropolitan areas spreads risk across diverse economic bases. It also limits risk to natural disasters that may devastate one area and impact real estate values.
Asset Class Diversification. Another way to diversify is to invest in different types of real estate assets. Industrial, retail, office, and multifamily assets are affected in different ways by different economic events. By owning different types of property, an investor can minimize the risks that any one asset class might suffer.
Long-Term Ownership Issues
A 1031 exchange can help alleviate some issues that arise when properties have been held for a long-time.
Management Burdens. A lot of owners of residential rentals get burned out after dealing with tenants, trash, and taxes. By exchanging out of their rental property and into a triple net investment property an investor can maintain their cash flow, but without have to deal with management problems.
Lack of Depreciation. One of the benefits of real estate investment is the ability to shelter income by the use of the depreciation expense. Properties held for an extended period of time (27 years or more) lose the ability to be depreciated. A savvy investor can exchange into a more valuable property to increase their tax basis and begin to depreciate their assets again.
The 1031 exchange is a valuable tool in the hands of a real estate investor. It can help defer capital gains taxes, buy more property, diversify risk, and alleviate issues arising from long-term ownership of the same assets.