The Advantages of 1031 Tax-Deferred Exchanges


New and experienced investors continue to take advantage of the 1031 tax-deferred exchange. With the strong economic growth and property appreciation that we have seen in many areas throughout the county over the past several years, it makes good sense.  Aside from giving the investor a tremendous increase in purchasing power, a 1031 exchange can also provide the benefits of leverage, consolidation, diversification, management relief, and increased cash flow and income.

 

LEVERAGE

 

Investors can take advantage of the 1031 tax-deferred exchange to acquire a more valuable investment property.  By utilizing the money they would have paid to the IRS in taxes, they can increase their down payment and improve their overall buying power to acquire a more expensive replacement property.  Thus, leveraging their cash and continuing to build wealth through real estate investment.

 

CONSOLIDATION/DIVERSIFICATION

 

With the flexibility of an exchange, an investor may exchange one property for several others, consolidate multiple properties into one, and acquire property anywhere within the United States.  For example, an investor can exchange two duplexes for a retail strip center, or take advantage of a new growth area by exchanging one property in California for three properties in Arizona.

 

MANAGEMENT RELIEF

 

Investors that own several rental properties are often faced with the burdens of intensive management and costly maintenance - which often leads to increased headaches!  An investor can increase profits and decrease time and effort by exchanging out of high maintenance rental properties and consolidating into an apartment building or NNN leased investment.

 

INCREASED CASH FLOW/INCOME

 

Cash flow and overall income can both be increased through a 1031 tax-deferred exchange.  For example, a vacant parcel of land that generates no cash flow or depreciation benefits can be exchanged for a commercial building that does.

 

INCREASED PURCHASING POWER

 

The following numbers illustrate the financial power of a 1031 exchange.
 

Capital gain is taxed at a maximum capital gains tax rate of 20% and depreciation is recaptured at 25% (for individual taxpayers).  In this example, the total taxes due would be: $76,750 (25% of $35,000 and 20% of $340,000).  Additionally, most states have a state capital gain tax that would be deferred through the 1031 tax-deferred exchange for increased purchasing power!
 

Original Cost (Basis)

$100,000

Plus Capital Improvements

$20,000

Less Depreciation

$35,000

Equals Adjusted Basis

$85,000

Sales Price

$500,000

Less Adjusted Basis

$85,000

Less Costs of Sale

$40,000

Equals Capital Gain

$375,000

Funds available for reinvestment w/o exchange (not including state capital gains due)

$383,250

Funds available for reinvestment w/1031 exchange

$460,000


If this investor decides to purchase a new property using all cash, the investor has an additional $76,750 to reinvest by utilizing a 1031 tax deferred exchange. If the investor decides to get a loan and the lender requires a 60% loan to value ratio, the values of a potential replacement property break down as follows:
 

 

Funds for reinvestment with 1031 Exchange:

Funds available with no 1031 Exchange:

Cash:

$460,000

$383,250

Plus new loan (with 60% LTV):

$306,667

               $255,500

Total Price for new investment:

$766,667

$638,750

Using the cash as leverage, the investor has an additional $127,917 of purchasing power.

 

It’s easy to see why a 1031 is a valuable tool for real estate investors. Have you spoken with your advisor and First American Exchange to set up yours?