Are you looking to finance your next buy-and-hold property? Consider trading up your current investment property with a 1031 exchange. Not only will this supply funding for your new investment, but it will also allow you to grow your tax-deferred wealth.
Here’s how to fund a buy-and-hold property with a 1031 exchange.
What Is a 1031 Exchange?
A 1031 exchange is the process of trading one investment property for another. The purpose of a 1031 exchange is to defer capital gains taxes. By exchanging properties, you avoid realizing any of your financial gains, which means that you don’t have to pay taxes on those gains immediately (you will have to pay the tax on all your gains when you eventually sell your tax-deferred assets).
If you were to sell a property traditionally, you would be responsible for paying capital gains taxes on the profits. But with a 1031 exchange, you don’t actually receive any profit because your gains are immediately rolled into a new qualifying investment.
How Does a 1031 Exchange Work?
You can sell a current income property and roll the proceeds into your new buy-and-hold property tax-free as long as both properties meet the qualifying criteria and adhere to a strict timeframe.
Before closing on the sale of your current investment property, you’ll need to seek the exchange services of an Accommodator. This third party holds the funds between the sale of the “relinquished” property and the purchase of the “replacement” property.
Basic property qualifications:
- Both properties must be “like-kind.” That means you exchange one residential property for another residential property or one commercial property for another commercial property.
- Both must be considered investment properties (not for personal use or resale). Primary residences, vacation homes, and short-term fix-and-flips don’t qualify.
- The replacement property must be of equal or greater value than the relinquished property.
- You must maintain at least the same level of debt in the replacement property as you had in the relinquished property.
- Both properties must be located in the United States.
Basic timeframe requirements:
- You must identify your replacement property within 45 days of closing on your relinquished property. While a smart property-finder tool is important for all real estate investors, it’s crucial for those on the short time frame of a 1031 exchange. There are several rules for identifying potential replacement properties, so it’s important to do your due diligence.
- You must close on your new property within 180 days of closing on the sale of your relinquished property.
Pros and Cons of 1031 Exchanges
This type of exchange comes with advantages and disadvantages.
Pros:
- You can upgrade your real estate portfolio, using your existing assets to fund your new acquisitions.
- You may be able to avoid depreciation recapture, which can be a big tax hit.
- Deferring taxes allows you to grow wealth faster because you can invest more money upfront and give it time to compound over the long term.
Cons:
- 1031 exchanges are complex and generally require professional management.
- Not all properties qualify.
- Given the rules about qualifying properties and timeframes, you must plan your 1031 exchange carefully.
The Bottom Line
You might already have the funding you need for your next investment property tied up in your current investment property. A 1031 exchange allows you to trade up to a new property without incurring an immediate tax bill for the gains on selling your current property. Be sure to invest some time in learning the ins and outs of 1031 exchanges, so you're ready to take advantage of one.
