Whether you’re looking to make a change in your vacation spot or wish to execute a 1031 exchange rental property transfer, there are plenty of benefits and drawbacks to understand. If you aren’t familiar, a 1031 exchange is a strategy to transfer ownership of one property to another without paying capital gains taxes on the original property. It works as a transfer of ownership between the properties to avoid the tax.
There are some specifics on what properties are and are not allowed to in a 1031 exchange. The law states that the properties should be “like-kind” but is actually very lenient in the transfers it allows. The complexities of this law mean you should always seek professional assistance for this kind of exchange. Sometimes, you’re even able to exchange vacation homes.
The benefits of investing in 1031 exchange rental property
Clients with high net worth most often utilize the 1031 exchange to put off the capital gains tax and maintain those funds for use. That’s where the advantages begin.
Above all else, the biggest advantage of the 1031 exchange is in the tax deferral. By not having to pay the capital gains tax on the initial sale of a property, you free up funds to put towards the replacement property whether you intend to use it as an investment or not.
The exchange allows a fair amount of flexibility in the way you use it. Some strategies could allow you to exchange one property for numerous others, purchase a property in another state, or exchange your current home for a rental property.
Pay expenses with exchange funds
Besides being able to keep and utilize the money that would otherwise go towards paying capital gains taxes, you can also pay other real estate expenses with exchange funds. Fees that could be covered include:
- Escrow fees
- Attorney fees
- Broker’s commission
- Tax advisor fees
Due to this process’s complexity, it is recommended that you have all the help you can get, so your strategy will likely include some of these fees.
The drawbacks of investing in 1031 exchange rental property
There is a reason that these exchanges aren’t far more common when people move to another property. Some of these drawbacks require you to be well prepared for the process before you get started.
The primary drawback of any 1031 exchange is the complexity around it. It is easy to do something wrong and put yourself in a difficult scenario or waste a lot of your time.
Seek out help ahead of time to ensure you’re as prepared as possible and ready for the process.
There are two time restrictions to the exchange that could make it fall through if you aren’t ready for them. The first is the 45-day Identification Period, where you must identify properties that you could purchase in the exchange. Failing to identify properties will result in a return of funds and a failed exchange.
The second period is the 180-day period to complete the purchase of the new property for the exchange. The 1031 should expedite some of the purchasing processes for you, but there is always something a home purchase could get hung up on.
Avoiding these drawbacks
The key to avoiding these drawbacks and finding a 1031 exchange rental property is preparing ahead of time. Know what you’re doing, know why you’re using a 1031 exchange, and seek out the help you need. This is not the time to wing it.
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