Real estate investors tend to earn their money on capital gains. When they sell a property, the amount of profit realized from the sale is considered a capital gain. The money is taxed in a similar way as the government taxes income – albeit at a lower rate. But real estate investors can temporarily defer tax payments by utilizing a 1031 transaction funded by a bridge loan.
The Basics of 1031 Transactions
A 1031 transaction is so named based on the section of the federal code under which it is found. Also known as a like-kind exchange, a 1031 transaction involves selling one property and purchasing another of similar value. Conducting such a transaction within the parameters of 1031 rules allows an investor to defer any capital gains tax that would otherwise have been assessed on the property being sold.
A simple illustration makes the transaction easy to understand. Imagine an investor looking to sell one of the properties in his portfolio. Revenues generated by the sale are temporarily set aside while he looks for a new property. He can use the funds to purchase the right property when he finds it. But there is another way to do it: use a bridge loan to buy the new property.
The Basics of the Bridge Loan
A bridge loan is a short-term loan normally offered by a hard money lender. A typical term would be 6-12 months. An investor would use a bridge loan to purchase a new piece of property with the understanding that the sale of his other property will generate the funds necessary to repay the loan. According to Actium Lending in Salt Lake City, Utah, this sort of thing is fairly common among real estate investors.
The Advantages of Using a Bridge Loan
There are definite advantages to facilitating 1031 transactions with bridge funding. At the top of the list is what the industry refers to as ‘reverse 1031 exchanges’. The ‘reverse’ idea is rooted in the direction of the transaction. Rather than selling a property and then using proceeds to buy a similar property, the reverse happens. The investor buys the new property first, then sells the other property.
Here are some of the additional advantages:
- No Investment Lapse – Although 1031 exchanges are subject to time limits, operating in reverse still gives an investor a fair amount of time to sell a targeted asset. But because he has already obtained a new property, there is no investment lapse.
- Closing Time-Sensitive Deals – 1031 transactions are often utilized to take advantage of high-yield properties. But getting a deal done often requires speed. When time is of the essence, a bridge loan can help an investor obtain a desirable property.
- Building Investment Value – 1031 transactions are also a good way to build investment value. Low-yield properties can be leveraged to invest in properties with higher potential yield. Bridge loans make it possible through reverse exchanges.
- Preserving Capital – Even when investors don’t rely on reverse exchanges, bridge funding allows them to preserve precious capital when it’s time to acquire the new property. The capital can be put to purposes that are far more productive than loan service.
Temporarily deferring capital gains taxes is the main strategy behind utilizing 1031 transactions. Exchanging properties of like value, by selling one and purchasing the other, allows investors to gradually build wealth while deferring their taxes into the future.
From my point of view, 1031 exchanges would not be as lucrative without access to bridge funding. The bridge loans made by firms like Actium Lending keep savvy investors in the game.