Exploring The Pros And Cons Of Rental Property 1031 Tax Exchanges

Purchasing and selling rental properties is a great way to build your wealth and create passive income. However, the sale and purchase of rental properties can also leave you with quite a significant tax liability at the end of the year. This is why many real estate investors choose to take advantage of tax break opportunities such as 1031 tax exchanges. Below you will learn more about this particular opportunity to defer the taxes from the sale of one of your rental properties by examining both the pros and cons that come along with the use of a 1031 tax exchange.

What Exactly Is A Rental Property 1031 Tax Exchange?

If you are not at all familiar with the use of a 1031 tax exchange, this refers to the IRS code 1031 which allows you to defer capital gain and income taxes which are typically due when selling one of your rental properties. Instead of paying this tax upfront, you will be able to defer your tax liability by using the money you receive from the sale to purchase a different rental property. 

The Pros

  1. Defer tax liability - The amount of tax that is due when selling a rental property can be significant. By allowing you to defer this tax liability a 1031 tax exchange allows you to maintain a more fluid flow of cash for the purchase of your next property. This tax deferment also allows you to carefully decide when to cash out on your real estate investment based on current tax rates at that time. This can greatly reduce your overall tax liability in the long run.
  2. Build your wealth - By allowing you to continue reinvesting any profits that you earn from the sale of your properties, rental property 1031 tax exchanges really present an amazing opportunity to grow your wealth and increase your net worth.
  3. Upgrade to better property - If the current rental property you own is not creating the passive income you were hoping for or requires a great deal of maintenance, taking advantage of a tax exchange will allow you to upgrade to a better property without the need to invest a ton of extra cash.

The Cons

  1. Tax-deferred is not tax avoided - Just because a 1031 tax exchange allows you to defer your tax liability does not mean it eliminates this liability. You will still be responsible for paying these taxes when the day comes that you finally decide to stop purchasing new rental properties. 
  2. Time limits - The IRS limits the amount of time that you will have to purchase a new property after selling your current rental property. In some cases, it may be difficult to locate and close on another property within the allowed time frame. 
  3. Strict rules and regulations - The IRS strictly enforces the many rules and regulations that govern rental property 1031 tax exchanges. Since these regulations can be rather complex and confusing, it is always best to work closely with a real estate law firm or tax professional when choosing to perform a tax exchange.