“[A 1031 exchange] is a wonderful way to keep your money working for you.” – Gary Keller, author of The Millionaire Real Estate Investor
Real estate is one of the most commonly held assets on most investor’s balance sheets. A real estate investment is tangible, it typically provides a source of income (rents), and has shown to increase in value over time. For these reasons, the idea of putting money into real estate as a way of building long-term wealth is pretty much a universally accepted truth here in the United States. As Mark Twain once stated, “Buy land, they’re not making it anymore.” Although the reality of real estate investing is a bit more nuanced than that (just ask any real estate investor that lost their shirt a decade ago), the overarching idea that limited supply and growing demand puts upward pressure on prices is spot on.
For those that have real estate investments and want to continue leaving their money invested in real estate, a 1031 exchange is an extremely powerful tool which can be used to compound higher returns on a real estate portfolio. For those that are unfamiliar with the term, a 1031 exchange refers to section 1031 of the United States Internal Revenue Code, which allows for real estate investors to defer capital gains taxes on their real estate sales as long as the proceeds from said sale are re-invested into a “like-kind” property. The definition of like-kind is very broad and includes almost any type of real property you can imagine other than a primary residence.
There is no limit to the number of times an investor can execute a 1031 exchange, so theoretically capital gains taxes can be deferred for decades or even wiped out altogether in some instances (more on this later). In other words, the IRS is giving real estate investors who utilize a 1031 exchange an interest free loan with no set repayment date. The logistics of a 1031 exchange can be a bit cumbersome and there is a cost to utilizing professionals (qualified intermediaries) who know how to navigate this space, but the benefits far outweigh these costs.
To bring this point home, let’s walk through an example. Client A is looking to sell a $1 million piece of real estate for any number of reasons (no longer geographically convenient, thinks this particular property is “frothy” in price, etc.). Although Client A is ready to sell this particular property, they would like to keep the money invested in real estate because they need the income and are comfortable with the asset class. Let’s also assume that Client A originally purchased the property for $500,000 a long time ago and has depreciated the asset down to a cost basis of $250,000. Additionally, let’s also assume that the going net yield (also known as a “cap rate” in real estate terms) on any replacement property is 7% after backing out all expenses (maintenance, insurance, vacancy, etc.) and that real estate in this particular area appreciates at 2% a year. Lastly, we will assume that Client A owns the property outright with no debt for the sake of simplicity.
Now let’s look at two scenarios where Client A either sells the property and reinvests the after-tax proceeds into a new property or utilizes a 1031 exchange to defer taxes and purchase a slightly larger property. In the table below, we have assumed a 7% frictional cost for selling a property to cover realtor fees and closing costs along with a flat $2,000 charge for the use of a qualified intermediary in the 1031 exchange. Also, let’s assume that after 5 years Client A is done investing in real estate and wants to invest in something else or just simply spend the money on themselves.
In the first scenario, Client A takes the tax hit on the front end and is left with a just over $700k to reinvest into a replacement property. Since the sale of the property put Client A into a very high tax bracket ($750k capital gain), the tax on their long-term capital gain includes Federal (20%) plus state (4.63% for Colorado) plus Medicare tax for high income earners (3.8%) for a total of 28.4%. All the money that was depreciated over the years ($500k purchase price - $250k cost basis = $250k) is taxed at a slightly higher rate of 25% federal plus the same state and Medicare tax for a total of 33.43%. On a positive note, when Client A decides to sell the property five years down the road, their tax bill is much lower because they have established a new cost basis and won’t be subject to high income earner tax rates. The taxes at the end of five years will only be the long-term capital gains rate of 15% federal and 4.63% state if we assume no deprecation over the course of the five year investment for simplicity.
In contrast, under the 1031 scenario, Client A only pays the 7% frictional cost of selling their property plus the $2,000 flat rate for the qualified intermediary. As such Client A is able to reinvest $928k into a new property which grows at 2% a year and kicks off 7% of net investment income. Although Client A pays more in taxes and fees under the 1031 scenario ($376k vs. $365k), they are much better off in the end and have an extra $94k to put in their pocket for their troubles. The main driver of the additional $94k in profits is coming from the extra income that is generated on a $928k versus a $705k property, which was only made possible by the interest free loan from the IRS for utilizing the 1031 exchange.
There are lots of different variables that can impact the efficacy of a 1031 exchange including the size of the transaction, an individual’s tax situation, and the expected real estate investment time horizon, which is why it is always smart to consult a tax professional and/or attorney before considering a 1031 exchange. But it is safe to say that as the dollar amounts and time horizons grow, a 1031 exchange becomes a no brainer thanks to the power of compounding.
Earlier I mentioned that in some instances capital gains taxes can be eliminated altogether. If in our original example Client A were to pass away at any time during their 1031 investment time period, the heirs to Client A’s estate would receive a step up in basis to the then current market value of the property, which would effectively eliminate the capital gains tax liability (estate taxes may still apply). As such, proper utilization of a 1031 exchange can be an excellent estate planning tool since the original owner can benefit from the investment income and pass along more capital to their heirs by eliminating the embedded tax liability. Under this scenario, a 1031 exchange goes from being a good idea to an absolute slam dunk!
In next week’s post, we’ll unpack a little more of the logistics of a 1031 exchange including some of the rules and timelines that have to be followed. Additionally, we will explain how a Delaware Statutory Trust (DST), which acts as a pooled investment vehicle, can add diversification to a real estate portfolio while helping clear some of the logistical hurdles many investors run into when trying to do a 1031 exchange.
Every investor’s situation is different. Since I am not a tax or legal expert, it is highly recommended that you consult an accountant or attorney before considering a 1031 exchange.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.