How To Leverage Your Portfolio With 1031 Exchanges

1031 exchanges remain one of the most powerful investment tools, yet they are also one of the most misunderstood and under-used. 1031s were created by the government to help investors increase their returns through continual investing. Investors need to understand how to leverage their portfolio using 1031 exchanges to best maximize future growth.
To put it in perspective, one can imagine 1031s as free capital with:

• 0% interest: The investor pays no interest on the money the government gives them.
• High LTV: The capital can be leveraged at the investor’s highest LTV capability. 
• No Due Date: Investor keeps the money as long as it is invested in real estate. 
• 85% Free Profits: The investor keeps 85% of what the government's (leveraged) money makes them—these are free profits from an outside money source.
• Potential Non Re-Payment: With proper long-term investment practices and proper financial planning, the investor may be able to avoid fully paying back the government’s money (this may also include not having to pay back any depreciation recapture).

Common misconceptions

The most common misconception with 1031 Exchanges is that they save you money. The thought process goes something like this: “If I do a 1031, I don’t have to pay the government their taxes this year; thus I saved a little bit of money.” However, there are two major problems with this line of thinking. First, 1031s by design only defer an investor’s tax obligation, thus the investor still owes the money and has not saved a penny. Second, this thought process requires the investor to look backwards at the property sold as a profit source—not forward at the properties to be purchased—and looking backwards inevitably decreases potential returns.

The irony of not understanding the profit-value of a 1031 is that so many people understand the profit-value behind IRA’s and 401(k)s, which are relatively similar. The benefit behind such retirement vehicles is that the money put into the investment compounds in a tax-free environment. Because the investment is not internally taxed, it remains larger and thus creates greater profits. The investor may ultimately pay taxes on withdrawal, but the since the taxes are only a percentage of the earnings, the investor freely retains a greater net wealth without added personal contribution. 1031s follow this same concept; by deferring the tax obligation on the investment’s gains, the investor has a greater core of capital from which to make money  and then pays a portion of taxes on what was earned (and sometimes, pays none at all).

Benefits of 1031 exchanges

Accelerated benefits of 1031s—beyond those of IRA’s and 401(k)s—come from the ability to leverage real estate. Through leveraging, the compounding benefits of pre-taxed money increase in scale. Additionally, the tax-free advantage can quicken an investor’s roll-over time with any given property, thus allowing investors to not only multiply their returns, but do so at a faster compounding rate. In short, tax free benefits of 1031 exchanges can increase capital, returns, compounding and the turnover of investments, all without additional risk—and often reducing risk. Regardless of market conditions, 1031 exchanges, when utilized properly, should provide immediate and future benefits to the investor.

Planning with 1031 exchanges

There is no question that 1031s will strengthen an investor’s returns. The only question is by how much. Tax free growth of real estate is becoming more popular, especially through self-directed IRAs. While self-directed IRAs are relatively new, 1031 exchanges have existed for more than seventy years but are still unfamiliar to many investors, who often believe that 1031s are restricive or overly complicated. 1031 exchanges are not inherently restrictive in their application, but there are numerous rules and regulations that should be discussed as part of the 1031 planning process.

Common sources of real estate advice (Realtors, Loan Officers, etc) often do not adequately cover the positive application of 1031 Exchanges. Investors should to take time out on their own to learn how 1031s can best be implemented into their own investment strategies and speak with those familiar with 1031s to learn how they can apply to specific investment goals. Investors may also wish to work with investment companies that incorporate 1031 strategies into their long-term planning and growth. Most investment groups do not do this, so be sure to ask.

Whatever road the investor takes to gain knowledge on 1031s is a good one. Increased returns are closer and easier that one might imagine.