The 1031 tax exchange is a much-used method for turning a little into a lot. Understanding how it works is critical to making the best use of this important investment tool.
The 1031 tax exchange is one of the key factors keeping a fire lit under the land boom. It takes its name from the section of the IRS code in which you will find it. Concisely, the 1031 tax exchange allows you to sell one piece of real estate and replace it with another one while deferring capital gains tax and recaptured depreciation to a later date when you choose to cash out of your real estate holdings.
If you have never done the math on how much faster a tax-deferred investment grows versus a taxable investment, this next section will get your attention.
INVESTMENT CASE STUDIES
Let’s say that Bob and Jim both have $500,000 to invest in land. Bob decides that he will try to grow his holdings by using the 1031 tax exchange provision to sell fairly-priced properties and buy under-priced properties. Jim is going to do the same thing, but without the use of the 1031 exchange strategy. You see, Jim has the attitude that capital gains taxes are likely to rise at some point in the next few years should a Democrat be elected president. He decides to take his gains now on each sale of land before the tax rate goes up.
On the surface, Jim’s strategy seems reasonable, but we shall see in a moment that it will actually cost him.
I will run the numbers two ways. First, I will assume that the capital gains tax stays the same over the entire period. This assumption favors Bob’s approach. Then I will rerun the numbers assuming that the capital gains tax stays the same for the next five years and then goes to 30% as Jim assumes. That would seem to favor Jim’s strategy of cashing out on each sale while the rate is low.
Next, let’s assume they each make four transactions (trading up to parcels of greater value each time) during the first five years, selling for a 25% gain in each transaction. After four transactions, they both hold the final property for a year and then cash out in the sixth year. Let’s further assume that they make cash purchases. The size of their bottom line would be scary you if they finance these purchases with 25% down. Their rate of return would skyrocket, but I’ll save that for another day. Here are the numbers.
Scenario 1 – capital gains tax stays at 20% (I used 20% as the total of federal and average for state cap gains tax): Bob’s property value at the end of the five years is $1,220,000. He cashes out for $1,076,000. Jim’s property value at the end of the same five years is $1,080,000. He cashes out for $1,037,000. In the end, Bob has $39,000 more than Jim has because he compounded a larger amount of money during each transaction and then paid his taxes at the end.
Scenario 2 – capital gains tax rises to 30% after fifth year: Bob’s property value is still $1,220,000 but he cashes out for $1,040,000. Bob still has a final property value of $1,080,000 and cashes out for 1,015,000. Jim still beats him to tune of $25,000.
These numbers aren’t exactly correct because there is cost associated with each 1031 exchange. You have to pay the intermediary. However, in my experience, this fee is typically well under $1,000 per transaction. Low enough we can forget it for now.
The conclusion is inescapable. Even in the very best case scenario for Jim, paying his capital gains taxes with each sale cost him money in the end.
If the capital gains tax rises in the future, it becomes even more imperative that you use the 1031 exchange after it goes up to maximize your investment return. For example, if the capital gains tax goes to 30% after the first year, Bob really waxes Jim because Jim’s net return on each transaction after the first one is much lower than Bob’s. In that case, Bob is still cashes out in six years at $1,040,000 but Jim cashes out at just $973,300. That’s a full $66,700 less.
Next week: part 2 of 4 – Ins and outs of 1031: Misconceptions