1031 Exchange Benefits:
1031 Exchange is one of the few techniques available to postpone taxes. The taxpayer has to pay taxes when the property is sold for cash. On the other hand, since an exchange does not generate cash, no tax is owed immediately.
By deferring taxes, the money that would otherwise be used to pay taxes can now be invested in another property. This helps in economic growth. The taxpayer effectively receives an interest free loan from the government which can be used for productive purposes.
Gains from recapture of depreciation is postponed.
The taxpayer can continue to avoid recognizing gains until his or her death. When the heirs inherit the property, the gain on the property could escape taxation due to the stepped up basis that they may obtain on the property.
This section can be used to build a strong real estate portfolio as the taxes that otherwise would have been on a sale can be used to invest in more properties or larger properties or higher end properties. An investor can build his or her net worth considerably by using this section to his or her advantage.
Section 1031 allows relocation of investment. It is not necessary that the properties in an exchange should be located within the same state. They can be located in any state. By exchanging properties, the equity in these properties tends to get relocated. Such flexibility encourages investment which in turn is favorable for economic growth.
Section 1031 increases leverage. Increased leverage can be achieved by way of tax deferment. Since there is no immediate tax outgo, the equity in the total property portfolio increases enabling the investor to invest more as he or she can use the size of the equity to carry a larger mortgage on a bigger or wider portfolio.
An investment portfolio should be well diversified so that risks associated with different investments can be evened out. Section 1031 helps the investor to achieve diversification, thus, reducing his or her investment risk.
Prior to the issuance of the safe harbor regulations by the Internal Revenue Service (IRS) in 1991, exchanges were subject to intense scrutiny in tax assessments. Since the issuance of these regulations, exchanges have become much less cumbersome and less expensive.
Section 1031 helps in consolidating a many properties into one or a few manageable ones for ease of management.