How Can a 1031 Exchange Help Defer Capital Gains Taxes

by | Sep 20, 2022

If you hang around the real estate investing space for any amount of time, you will hear the term “1031 Exchange.”  You’ll likely be curious why this strategy creates so much excitement, so that is what we’ll walk through in this short article.

A 1031 exchange is a tax strategy that allows you to sell a property and purchase another “like-kind” property while deferring your capital gains tax on the sale.  Essentially, you get to kick the tax can down the road until some further time or even possibly forever.  You can quickly see why this would get so much attention from real estate investors, and you can start to understand how many people pay little, if no taxes on their real estate gains.

Let’s walk through an example so you can see how powerful this can be.  Imagine you invest $100,000 in an apartment syndication that pays you 5% cash on cash return every month, and the investment goes full cycle in 5 years doubling your initial investment.  Each month you’ll receive $416.66 in cash flow ($23,749.62 over the lifetime of the hold period), and $76,260.38 upon the sale of the asset.

Without the 1031 exchange, you’d have to pay long term capital gains taxes on the $76,260.38 at 15-20% depending on your income level ($15,250.08 at 20%).  Now, if you reinvested the $61,010.30 that’s left over after paying taxes in addition to your initial $100,000 investment, you’d be earning $670.88 per month in cash flow on a similar investment type (5% COC and double in 5 years).

If you chose to leverage the 1031 exchange, everything would be the same on the front end except for paying taxes, but you’d have $176,260.38 invested into the next deal creating $734.42 per month in cash flow.  The extra $63.54 per month is not super exciting, but when you take this out to three full cycle deals, your capital has grown to $547,504.10 with the 1031 exchange strategy compared to $417,328.10 without the 1031 exchange.  If you placed those two amounts in another investment earning just 5% returns, your monthly income would be $2,281.27 compared to $1,738.87 – 31% more!

There are several rules and timelines that you will need to follow, but here are four of the big ones to know before considering this option:

1.     Like-Kind – You’ll be required to exchange one investment property for another investment property of equal or greater value.  It’s important to note that there are rules about switching between investment types so it’s critically important to work with your tax professional to make sure you’re moving into the right investment type

2.     Intermediary – You’ll need to engage a 3rd-party intermediary to manage the funds as they move from the sold investment to the new investment.  If you’ve already sold your investment and taken position of the proceeds, you can’t go backwards to initiate a 1031 exchange

3.     45-Day Rule – Once your initial investment is sold, and the intermediary has taken possession of the proceeds, you will need to identify a replacement property within 45 days.  If you fail to identify a property in the 45 days, it will automatically create a taxable event

4.     180-Day Rule – You must close your next purchase within 180 days of the initial sale date on the original investment, or a taxable event will occur again

As you can see, the rules and timelines can make this a very tedious process, so it is extremely important to work with the right professionals.

Whether you chose to leverage this tool or not, it’s important to know that it is available, and it’s a great way to increase your returns by as much as 31% by simply jumping through a few hoops along the way.

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