A Sale vs 1031 Exchange

The benefits of IRC Section 1031 exchanges can be tremendous! Conversely, the damage of not doing an exchange can be simply devastating. Investors are often able to defer tens or even hundreds of thousands of dollars in capital gain taxes, both at federal and state levels. If the requirements of a valid §1031 exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it. This essentially results in a long-term, interest-free loan from the IRS. Additionally, upon the death of the property owner, heirs may inherit the property at a stepped up cost basis – eliminating the tax burden completely.

Why Exchange? An Example:

  • Someone purchases a rental property for $200,000.
  • They sell the rental property for $400,000.
  • Upon the sale, there is $200,000 of debt and the property has been fully depreciated.
  • The capital gain is approximately $350,000 (assuming 75% of the property is depreciable). If the investor does not do an exchange, federal capital gain taxes could look something like this:
Item
Tax Liability
Item
Depreciation Recapture
$150,000 x 25%
Tax Liability
$37,500
Item
Federal Capital Gains Tax
$200,000 x 20%
Tax Liability
$30,000
Item
State Capital Gain Tax (CA) (rates vary)
$350,000 x 9.3%
Tax Liability
$32,550
Item
Total Capital Gain Taxes
Federal & State
Tax Liability
$99,050
Enough said! I’d like to talk to a 1031 advisor!

The Numbers are Undeniable

Let’s take a look at a few scenarios to show the power of a 1031 exchange.

  • Purchasing Power: The first comparison analyzes the value of the new property that could be acquired in a sale versus an exchange. It illustrates that the real power of a tax deferred exchange is not just the tax savings—it is the increase in purchasing power generated by this tax savings!
  • Rental into DST: Look at the difference in cash flow when utilizing an exchange to go from an actively managed property to to a passive cash flowing investment like a DST.
  • Raw Land into NNN: Most raw land sellers have a low cost basis and are seeking a passive income stream. Keeping the proceeds in real estate by utilizing a 1031 exchange can make a huge difference in leveraging the value of their property.

 

The Advantages Are Clear

  1. Preservation of Equity
  2. Maximize return on investment
  3. Increased cash flow from larger properties

Sale vs. Exchange - Purchasing Power

Comparison:
Sell
Exchange
Comparison:
Equity
Sell
$200,000
Exchange
$200,000
Comparison:
Tax Liability:
Based on 29.3% state/fed tax rate. Rates vary.
Sell
$99,050
Exchange
$0
Comparison:
Cash to Reinvest
Sell
$100,950
Exchange
$200,000
Comparison:
New Property Price
Assuming 75% Loan to Value
Sell
$403,800
Exchange
$800,000

Sale vs. Exchange - Rental into DST

Comparison:
Sell
Exchange
Comparison:
Original Cost of Rental:
Also known as the "cost basis"
Sell
$200,000
Exchange
$200,000
Comparison:
Sales Price:
Sell
$400,000
Exchange
$400,000
Comparison:
Mortgage Balance:
Upon the sale
Sell
$200,000
Exchange
$200,000
Comparison:
Depreciation Recapture
*Assuming 75% of the property is depreciable
Sell
$150,000
Exchange
$150,000
Comparison:
Taxable Gain:
Capital Gain + Depreciation Recapture
Sell
$350,000
Exchange
$350,000
Comparison:
Tax Liability:
Based on 29.3% state/fed tax rate. Rates vary.
Sell
$99,050
Exchange
$0
Comparison:
Cash to Reinvest
Sell
$100,950
Exchange
$200,000
Comparison:
Reinvested into DST earning 5.75%
Annual ROI (before tax)
Sell
$5,804
Exchange
$11,280
(+$27,720)
Comparison:
5-Year ROI
Don't waste your hard-earned equity!
Sell
$29,020
Exchange
$56,400
+$27,380 more

Sale vs. Exchange - Raw Land into NNN

Comparison:
Sell
Exchange
Comparison:
Cost of Land:
Also known as the "cost basis"
Sell
$200,000
Exchange
$200,000
Comparison:
Sales Price:
Sell
$2,000,000
Exchange
$2,000,000
Comparison:
Gain:
This is your "taxable gain"
Sell
$1,800,000
Exchange
$1,800,000
Comparison:
Tax Liability:
Based on 29.3% combined state/fed tax rate. Rates vary.
Sell
$527,400
Exchange
$0
Comparison:
Net Proceeds:
Sell
$1,272,600
Exchange
$1,800,000
Comparison:
Reinvested at 6.5%
Annual ROI (before tax)
Sell
$82,719
Exchange
$117,000
(+$34,281)
Comparison:
5-Year ROI
Don't waste your hard earned equity!
Sell
$413,595
Exchange
$585,000
$171,405 more