How 1031 Exchanges Build Generational Wealth

How 1031 Exchanges Build Generational Wealth

  • Nick Emerson
  • 08/17/22
Section 1031 of the Internal Revenue Code sets the structure of transactions known as 1031 Exchanges. In a nutshell, 1031 exchanges permit filers to defer taxes when an investment property is sold along with the acquisition of real property that replaces the investment property. In essence, one investment property can be exchanged for another. Additional benefits are also available to those who want to utilize 1031 exchanges to create generational wealth.

1031 exchanges permit investors to tap into the appreciation value of real property. Investors can use these tools to increase their buying power, improve their investment portfolios, and learn new techniques regarding investments and real estate.

The role of 1031 exchanges in investment strategies

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Section 1031 of the Internal Revenue Code allows investors to save money on the capital gains taxes that are assessed when an investment property is sold. Individuals can fill out a “like-kind exchange” that will defer capital gains taxes if the proceeds from the sale are applied to the acquisition of real property. “Like-kind” refers to real property kept by an individual or entity for investment or business reasons. Many investors want to trade their investment properties for new real property investments, and the 1031 exchange provides the flexibility that can benefit investors and their financial portfolios. 1031 exchanges are one of the best ways to build wealth.

Creating wealth using 1031 exchanges

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Saving money on capital gains taxes is not the only reason individuals take advantage of 1031 exchanges. Altering investment portfolios can help analysts, investors, and financial advisors adapt to market trends and developments. Individuals often use 1031 exchanges to create generational wealth.

Eliminating taxes for beneficiaries

Inherited property is often taxed multiple times. Net investment income tax, depreciation recapture, and capital gains taxes are just some of the taxes that are assessed on inherited property. 1031 exchanges allow owners to reduce or cancel these taxes on inherited property when the property passes to a new owner. Surviving spouses and beneficiaries in community property states receive a “step up” in basis when inheriting real property — the property’s value is brought up to match the fair market value. This eliminates the deferred taxes when a real property owner dies.

Estate planners often advise their clients to take advantage of the provisions contained in section 1031 of the Internal Revenue Code. However, estate planners often focus on providing their clients with advice regarding 1031 Delaware Statutory Trusts, or fractional ownership.

Taking advantage of new investment strategies

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The majority of real estate investors acquire new properties by acquiring an ownership interest in fee simple. This particular ownership interest permits one individual owner to have complete control and ownership of real property. The owner is responsible for all the duties and privileges of real property ownership, including costs, management, and repairs.

Delaware Statutory Trust properties enable investors to own a fraction of a real estate asset or portfolio and take in a share of the income the individual ownership interest produces. These trust properties fall under the Internal Revenue Code’s definition of “like-kind” property. Individuals who are interested in acquiring more ownership properties but do not want to take on the burdens and responsibilities of property maintenance may benefit from Delaware Statutory Trust properties and 1031 Exchanges.

Reducing risk by diversifying holdings

The replacement property under 1031 Exchanges can be a different type of property from the one which was sold and exchanged. This freedom permits investors to think about how to strengthen their portfolios through diversity. After all, keeping real estate property holdings homogenous can weaken returns on investment. Developing markets may arise, and investors will want to learn more about investment opportunities that can benefit them and their beneficiaries in the future.

Frequently, investors are interested in exchanging investments in residential property for investments in commercial property. 1031 exchanges enable new and seasoned investors to learn more about investment properties that can strengthen their portfolios.

Improving purchasing power by creating wealth

Benefiting from a tax-deferred exchange and increased buying power helps investors learn more about their investments. Improving one’s portfolio will produce added value in the future, and this will help investors acquire novel properties that strengthen their portfolios.

When a new property comes on the market, an investor may be able to use a 1031 exchange to purchase the property. Increasing return on investment over time is one key to creating wealth over the long term that will accrue to one’s beneficiaries. Portfolios may be at risk of deteriorating if they are not updated and revised over time. 

Maximizing return on investment by deferring capital gains

Taxes can decrease the return on investment for those who invest in real property. Sellers of investment property may lose significant sums to capital gains taxes. The long-term Federal capital gains tax sits at a rate of 15 percent for individuals with incomes of $40,000 to $441,450 and 20% for investors who earn more than $441,451 per year.

After federal taxes, investors and individual property owners will be taxed according to the laws of the state where the property is situated. In the state of California, investors pay up to 13.3% in state capital gains tax. Other states also charge a capital gains tax rate of over ten percent. Investors may end up paying significant sums in capital gains taxes after paying both federal and state taxes.

Investors can use 1031 exchanges to defer paying these capital gains taxes and instead roll the tax into acquiring an investment property. Replacing one investment property with another enables investors to pay less overall capital gains taxes and reduce the likelihood of suffering cash flow issues. 

Making it work for you

Broker Nick Emerson understands how important it is to keep abreast of laws and regulations that affect real estate investors. He is immensely knowledgeable about investment properties that can improve the strength and diversity of your investment portfolio, and the team is happy to answer any and all of your questions. The Emerson Group has been expertly and efficiently helping clients buy and sell real estate and build their financial portfolios for over ten years. You could be next!

*Header photo courtesy of the Emerson Group

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