The concept of 1031 exchanges sounds good. The idea is that when you sell an investment property, you can buy another investment property of greater or equal value, and tax is deferred into the future.
My problem with this is that I think capital gains tax rates are low right now and are only going to go up from here. In fact, they have already started going up. Another problem is that you can’t touch your profits, you have to move the money into the new property. After making a big profit, I sure like having the cash in my hands.
Another problem is that you have limited time periods in which to do things, like identify replacement properties. A lot of sales do not go through. In the meantime, you’ve put a lot of effort into finding replacement properties. If you have to re-list, you have to duplicate all that effort. You may also rush into a so-so investment instead of a really great deal because there is no really great deal available when you need one for 1031 exchanges.
In summary, I don’t view current long term capital gains tax rates as being too high. Also, you don’t even really pay the full rate because you get to wash a lot of pent up paper losses against your gains. You get to deduct all your expenses against your rental income while you own the property, but also get to deduct a fictional depreciation on the building. In actual fact, your property is usually going up in value. (Sure, we had deflation for a few years after 2007 but that is kind of a rare thing in historical terms.) When you sell, some of that depreciation gets recaptured, but not all of it. I’d rather pay the tax now than wait to see how high tax rates will be in the future.
There are a couple of slick ways to make 1031 exchanges work for you, if you don’t need the cash from your sale right now.
Here is one idea I’ve heard: you keep exchanging up until you are near retirement. Then you exchange into an ultimate beach house that you can use a rental (no HOA restrictions or zoning restrictions). After renting that for a few years, you make it your primary residence, then, you live in it until you die, giving your heirs a stepped up basis. Or, after a couple of years of living in it, you can use the exemption on primary residences to avoid capital gains tax altogether.
If one of these strategies sounds interesting, discuss them with a 1031 exchange expert to make sure they will work for you. I don’t claim to be a 1031 expert.
I don’t view tax laws as being static and fully expect tax rates to go up as the debt goes up. Advantages we have now may go away. So I prefer to live for the day and put my profits in my pocket.