Why You Should Avoid Tax Deferred Exchanges Whenever Possible

by | BiggerPockets.com

My first few dozen tax deferred exchanges were in the days before what’s now called the delayed exchange — or back in the dinosaur days, a Starker exchange. You think they’re fun now? Try closing all properties involved in the same moment in time, at least virtually. The pretty phrase used back then was simultaneous close. I owe countless sleepless nights to that innocuous phrase. Today? Tax deferred exchanges are far less stressful, at least in most cases. The rule requiring the closing of all properties simultaneously no longer applies. We can thank the Starker family for that, another story, but incredibly interesting.

It’s Still About Deferring Taxation — and More

This isn’t about the many, many rules governing tax deferred exchanging. This is about why you should or shouldn’t opt to execute one. The oversimplified guideline is the policy taught to me eons ago.

Don’t execute a 1031 exchange unless there’s no other choice, AND it so vastly improves your status quo the decision is a Captain Obvious no-brainer.

The result of a 1031 should be a significant increase in cash flow, or capital growth, or both. Sometimes it can be part of a sideways move of sorts. That is, a simple improvement in the quality of your buildings and/or their location(s). In sports that’s known as addition by subtraction. You rid yourself of previous unfortunate investment decisions and the taxes that may’ve attached themselves to your escape. This happens more than you might imagine. An example came over a decade ago in my last active SoCal years.

The PorTfolio Rehab Exchange

Investors called me wondering if I could help them rethink their investment plan for retirement. They’d just began regrouping from being kneecapped by the Nasdaq crash. They’d watched what was to be a pivotal part of their retirement income lose over a third of its value almost faster than they could watch it happen. Ouch. That was the bad news.

The kinda sorta good news was that they had four small income properties. But what a truly motley crew.

A single family home older than Grandma, and in far worse shape, and in a neighborhood I’d never put her. A truly depressing piece of property. A well located condo, but with a poor tenant. A triplex in a blue collar neighborhood that’d seen better days. Saving the best for last, a home located on an almost impossible lot location that was the former host of a massage parlor. I think. It was sure set up that way, no doubt about it. Like I said, a motley crew. What to do?

The #1 priority was to improve all facets of this portfolio through several exchanges. We first established that there simply was no alternative to exchanging, tax deferred, as the taxes were gonna be prohibitive. We did so, and they ended up with an equal number of properties which all sported vastly superior locations and were all in much better physical condition. The management drama disappeared. Their cash flow zoomed. The most important improvement though was the almost instant increase in the velocity of their capital growth rate. Though the process took several months and was a gigantic logistical hassle to say the least, they were all smiles when the last exchange closed.

Related: BP Podcast 017 – Finding Mentors, Facing Retirement, and Note Investing with Jeff Brown

What’s the Downside of Tax Deferred Exchanging?

First, allow me to warn you of a mistake more common than people think.

Let’s say you have a free ‘n clear property you wish to refi. The lender appraises it for $500,000 and agrees to lend you $300,000. So far, so good. It’s not a taxable event, and you’re good to go. You invest the cash into more property. Next year about the same time you decide you’d like to do a tax deferred exchange with the refinanced units. You do so, exchanging your net equity for property you’re convinced puts you in a superior position then and for the foreseeable future. You followed all the rules. Man, you’re in for a rude awakening. Here’s why.

Your buddies at the IRS will, very possibly, tell you that your previous refi just a year earlier, was executed in your anticipation of this exchange. They will then say you owe taxes on that $300,000 as if you took it out of the exchange itself, directly. Oops. They’ll label it as ‘boot’, which will then trigger a capital gains tax bill for which you may or may not have the cash to pay. Remember, you bought more property with that money, and it’s long gone. Every time I’ve seen this happen first hand it’s been without bad intent by the investor. They just didn’t know and nobody around them knew either. ‘Course, the IRS cares not whether you knew the rules at the time.

It’s a great example of the one of my favorite axioms.

It’s not the answers to the questions we know to ask that get us. It’s the answers to the questions we wouldn’t ever know to ask that nail us. This is why it’s so foolish to ‘research’ 1031s then try one. You might be lucky and come out smellin’ like a rose. Or not.

The 2 Main Negative Consequences to a Tax Deferred Exchange

1. More likely than not your annual depreciation amount in terms of dollars will be less than if you’d simply sold the old property then bought the new one(s). This is due to the rules requiring the old baggage from your relinquished property being brought with you in the exchange. The short version is that you bring the old depreciation amount with you. Then you get additional depreciation from your newly acquired property, but at a reduced amount. Instead of subtracting the value of the land then dividing by 27.5 (residential), you’re only allowed to depreciate the difference in the debt you left and the debt you acquired. But not the whole debt, so stop grinning. Ya still hafta subtract the land value from that figure.

2. If you ever wanna consider taking a straight sale in the future, a tax deferred exchange will cause your potential capital gains tax to be higher. This is a direct result of the IRS formula for computing that gain. If you’d just bought the property in a tradition purchase, your original cost basis would’ve been the price you paid, give or take. But since you exchanged into it, you brought with you the previous property’s adjusted cost basis. By IRS definition this will result in the formula beginning with a lower original ‘cost’. So, instead of maybe paying $400,000 in a straight purchase, the formula might say your actual bottom line ‘origninal’ cost was much lower. Obviously that fact alone will increase your gain which will in turn increase your potential tax bite.

If you can stomach the taxes and avoid a tax deferred exchange (IRC code section 1031) it’s more likely than not in your best interests to do so. 10-20 years from now you won’t be able to find, nor will you care about the taxes you paid ‘back in the day’ on good ol’ Maple Street. But you will definitely smile as you tally up the taxes you didn’t hafta pay due to higher depreciation numbers and lower capital gains.

Don’t mistake this for a policy. The decision whether or not to sell/buy or exchange should never be taken lightly or given short shrift. It’s often one of the most pivotal decisions a real estate investor makes in their lives. Make that decision a solid and informed choice.  In fact, sometimes the choice is neither. Either stand pat, or refi and buy more. I’m not a fan of the ‘policy’ of  keepin’ everything you acquire ’til death do you part. That ‘school’ of thought simply does’t compute with me, as they’re constant refinancing to buy other properties results in far too many unintended consequences. Sometimes refinancing a property is exactly the thing to do. But that’s another topic altogether.

Photo: Alex Dram

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.


  1. stuart Stevens on

    I have some difficulty understanding why the #2 main negative is actually a negative. It appears that you have just deferred taxes which is generally not a negative. The profit from the first exchange is passed onto the basis for the 2nd property. When the 2nd property is sold, you pay taxes on the profit for both the second and first properties. The alternative is to pay taxes on the first property when it is sold and then taxes on the 2nd property when it is sold.

    • Jeff Brown

      You’re correct, Stuart, but it’s about dollars paid in taxes, right? The analysis will show that in too many cases a tax deferred exchange didn’t really save all that much in taxes. It was done to avoid the ‘sin’ of paying any taxes when unnecessary. The point I made is that very often, the reality is that the taxes you might pay on the 2nd property in the future, could be FAR less than if an exchange had been eschewed in the acquisition of that 2nd property.

      Sometimes, Stuart, the taxes owed or deferred would be so high as to make even a tax deferred exchange distasteful. This is due to the almost non-existent cost basis the relinquished property might have at that point. If it had been depreciated virtually down to the land value, the cost basis would be negligible. So, that taxpayer would then be saddled with that baggage years later when they might desire to sell the 2nd property. Taxes at that point would no doubt be onerous to be kind. In cases like that it often makes more sense to take the refi and invest ‘anew’ approach.

      When the analysis is done, the decision is almost always pretty easy to see. That’s where a solid CPA with real estate investment tax experience is invaluable. In the end, it’s about whether or not the investor’s status quo has been significantly improved, AND that down the road they haven’t unnecessarily and appreciably reduced their options menu.

      The investor with the most options, wins.

      • I’m confused as well. It appears that what you are saying is that you should choose to pay some of your taxes now so your tax bill later isn’t as big. How does that make sense? Given the time value of money – the fact that the money you aren’t paying in taxes now can be invested in more real estate – why would you want to pay taxes before required? Using that logic, why wouldn’t you just make voluntary payments against future taxes all the time?

        • Jeff Brown

          Hey Adrian — Let me answer your question with a question or two.

          Extending your preference for avoiding taxes by deferring them in 1031s — How will your after tax income look in retirement? If, far down the road, after several 1031s, you have a desire to sell, what consequences might result?

          When the taxpayer/investor finds themselves wanting cash, the reason is irrelevant, and their adjusted cost basis on everything they own is a bit more than a StarBucks cup, they’ll be slaughtered. I’ve seen this dozens of times first hand. It’s not that the investor can’t end up with the same portfolio by paying taxes. They can. Also, it helps when this topic isn’t viewed as ‘one size fits all’ which is ludicrous on its face.

          We’ve gotta stop worshipping at the altar of 1031s. Exchanging is merely another tool available for use when it makes sense. It doesn’t always make sense any more than selling and paying the taxes. Allow deep and knowledgeable analysis make the decision an easy one. In my experience, unbiased, objective analysis virtually always uncovers the no-brainer move.

          Sometimes the answer is ‘none of the above’, which can mean stand pat, or simply refi and buy more property or whatever else your plan deems prudent.

        • For some reason I couldn’t reply to your post, so I’m replying to my own.

          First of all, I agree that each situation should be analyzed on its own, and there can be no universal answer.

          I get your argument, which is that when you defer you could have a large capital gains tax bill later. However, the alternative is basically “prepaying” part of that bill now, and I don’t understand the incentive to do that voluntarily.

          The only reason I can think of is that you expect the capital gains rate to increase dramatically before you expect to sell the property, which I don’t think even Ben Bernanke could predict.

          I can’t imagine how deferring taxes could decrease your after tax income in retirement – maybe you could expand on this.

  2. I am happy with my 1031X. Sold CVS Drugstore at 1.60 Million, and bought Walgreens for 4 million, from cash from sale. So, lots of extra depreciation, now have negative income!!!!

  3. Yes some of my clients have purchased drug stores NNN as well.

    What this really comes down to is a great team that represents the CLIENTS best interests. For example I will not tell someone to buy a commercial property just to get a commission. If I think the property has merit and reaches the objectives they have expressed to me then I will pass It along for their consideration.

    Just like a professional 1031 company WILL tell you based on your situation why you might want to or not want to exchange. A company that asks nothing and says “Let’s do it! ” you need to run from that company as fast as you can. Quality companies put people first to help them try to be successful and not to make a quick buck off of them and treat them as a number. For 1031’s you need to ask, ask, ask questions from the correct people to make an informed and knowledgable decision for your set of circumstances.

  4. Jeff,
    Another way to avoid paying taxes is taking on a partner in a property. Say you paid 800k cash for a property and its now worth an even 1 mil. You bring on a partner who can get a 100% loan for the 1 mil and he does so putting the million into the account and you have a 200k profit. You then dissolve the partnership and walk with the cash in the account and the partner has the loan against the property. Some more seasoned guys on here probably could explain this in more detail but I don’t think the new partner can bring any cash into the deal as this would trigger a disguised sale.

    • I seemed to combine two different strategies. The one I was trying to explain was that you bring on a partner, refi the property, then the owner looking to exit the property’s share of the company is reduced to say 5% as you must retain some ownership of the property. The “seller” then withdrawals the cash from the business. The “buyer” could also bring cash into the business as well instead of doing a refi.

      • Jeff Brown

        I still think the IRS will possibly wanna backtrack through the entire setup. You exiting while simultaneously decreasing your ownership share at least implies you may have ‘sold’ your interest, regardless of what you intended. I’d be wary.

      • A strategy I have heard is you do several exchanges then move into the last one and then sell it as your primary residence and you can eat up all the old gains via the tax exemption.

        I have not done it but have read about it being a way to totally avoid the taxes. One book I read that suggested it was written by a real estate and business attorney so that makes it seem more legit in my mind. 🙂

        • Jeff Brown

          Let’s take the reverse, Shaun, which is far more common. A person buys a home in which to live, and does so for many years. They decide to live elsewhere, but decide to keep the home instead of selling it, turning it into a rental house. The IRS says the value will be treated as follows.

          For the years you lived in it as your primary residence, it will be treated as such. From the day it becomes a rental it will begin a ‘new’ life. From that day on any increase in value will be treated like any other investment property. So, when you sell it, some of the proceeds will be treated by the tax code as a residence. The rest will be treated as the sale of an investment property.

          I’ve never ever met anyone who traded and traded for years, all of it deferred, and got away with owing no taxes simply cuz they ‘converted’ the property to their residence. Never. Ever. But I’m always willing to learn something new.

  5. Jeff Brown

    Adrian — I see the false assumption now. When you pay a relatively small cap gains tax bill now, you’re not ‘prepaying’ anything. You’re done, case closed. You then create a new chapter, unfettered by any baggage from before. Whether or not cap gains rates rise or fall doesn’t enter into my thinking unless there’s a compelling reason to believe something’s obviously imminent. An example of that in my experience was the mid 80s. Congress passed TEFRA, which turned many RE investment laws/regs upside down. It was scheduled to take effect the next Jan. 1st. The last quarter of the immediately preceding year was a Force 5 nightmare for everyone in the industry, as everyone and their Uncle Fred HAD to close on or before Dec. 31st.

    Whenever we buy more property instead of trading into it, we gain more tax shelter, and create a far more beneficial cost basis. What happens is that those who believe as you do end up trading ad infinitum for 25-40 years. They proudly showoff their cash flow. Meanwhile, every April 15th they’re dressed in sack cloth and ashes. The bottom line is to recognize up front that 1031s are akin to very sharp double-edged swords. Unsheathe only after serious analysis, both short and long term.

  6. It seems that a 1031 isn’t a great idea if you intend to sell.
    If you go for “Swap til you drop” type approach I don’t see any pitfalls.
    To me it seems you want to have a portion that hasn’t been through exchanges so if you have to sell something to get cash you can keep the other plan going and not have to pay all the other taxes.

      • Jeff Brown

        That approach can sometimes work, Kris. As long as the estate qualifies for stepped up values, and the original investor, while alive, doesn’t mind a significantly lowered after tax (cash flow) income. Your approach was stellar, ending up with NNN investments. I salute you.

        • Thanks Jeff, income from NNN was 4.5% COC,not great but fair, but my other investment in TIC’s was bad, hardly 1%, and may lose some of the properties, but has non-recourse loan.

    • Jeff Brown

      The properties that you end up with in retirement, Shaun, will spin off income virtually naked at tax time. Retirement is no different than before retirement. We can only spend after tax income. Serial exchangers find this out the hard way sometimes.

        • I have not done any exchanges just have done some non-exhaustive research on them.
          I don’t quite understand what you were saying about the depreciation in the article. I assume at least there was something not quite right about the semantics of what you were saying about differences in debt, since you depreciate the purchase basis (Price paid + any costs to put it into service) not anything to do with debt on the property.

          Are you saying that it is something like you sell a place for $100K that you made $20K on. You 1031 into a place that cost $200K but the rolled over profit reduces the basis to $180K, before land value is taken out?

          Is it something different where you would actually lose time on the depreciation. Since what I described would seem to reduce the amount each year but not the length.

          If the length doesn’t change the income is no more naked if you exchange. Yes probably less sheltered but not naked.
          If the worry is tax write-offs then refi the place and pull out a bunch of cash. Interest on the new loan now shelters some of the income. Take the money and buy another piece of real estate that will have all new fresh sexy depreciation for you. And since you don’t plan on selling the exchange property, ever, the pitfall mentioned in the article (Which is another good reason to not sell your exchanged properties) will not happen.

  7. Jeff Brown

    What reduces your basis, Shaun, (among other things) is accumulated depreciation over the hold time. If you paid $100k with annual depreciation of about $3k/yr, with a holding time of 7 years, your adjusted cost basis would then be reduced by $21k, resulting in an adjusted basis of $79k. Your profit figures in to the calculation of capital gain, whereas your basis is calculated by original price, plus any capital improvements, minus depreciation, plus any costs of sale on the way out.

    The analysis telling us what may be the best route to take involves the comparison of selling/paying taxes; doing a 1031 exchange; or refinancing and buying more property. For some, using multiple strategies synergistically, sometimes a partial 1031 can be added to the options list for analysis. Not only will the answer be different from one investor to another, but it’ll often be different from one property to another for the same investor.

    If you begin at age 25, retiring at 65, and exchange all the time, regardless, so as to never pay cap gains taxes, you’ll accomplish that objective, no taxes paid. At retirement you’ll have, if it was your objective, a portfolio free of debt. As time passes you will have become risk and debt aversive. As the time runs out on properties held the longest, depreciation would, at some point preceding retirement, begin to wane. Due to the decades of constant exchanging in order to build your net worth and ultimate retirement cash flow, your aggregate adjusted basis would tend to shrink. A smaller depreciable basis with the clock ticking on it’s ultimate demise are two lines you don’t like crossing. This is especially true in retirement.

    Though interest is surely deductible against rental income, it’s also an very effective eraser of cash flow. At some point in time, you’ll opt for cash flow over more debt. It’s almost inevitable.

    If you live to be say, 85 years old, your portfolio’s tax shelter will have been consistently shrinking then disappear. That’s not necessarily a tragedy if your cash flow is huge, and your lifestyle doesn’t demand more than is left after taxes. Also, as the portfolio’s individual buildings age, the predictable rise in repairs and maintenance will add to the shrinkage of after tax cash flow.

    Again, it’s all about the analysis. The main point is that the lifelong avoidance of cap gains through the use of tax deferred exchanges can sometimes produce unintended consequences the investor won’t appreciate.

  8. James Hall

    Hey Jeff. I know this is a very old post but I have a question

    assuming a taxpayer is single and has taxable income greater than or equal to 38k

    LT cap gains rate = 15% for taxable income ranging from 38k – 414k and 20% for taxable income greater than 414k

    Ordinary income tax rate = 25% – 39.6%

    with these rates I am finding it difficult to see the benefit of a 1031x

    what do you think?

    • Jeff Brown

      Hey James — IF the only comparison is ordinary rates vs cap gain rates, then I’m with you. In most real life circumstances it’s more about future shelter, potential for increased cap gains taxes in future sales, and how much property can be acquired in each scenario.

      If you pay cap gains, but the tax amount significantly decreases the value of what you can acquire, you may decide on deferring the taxes. It’s always based on each investor’s specific circumstances and agenda(s) at the time of the decision. For example, what if your taxes were $150k, which would, at say 25% down payment amount, cost you the opportunity of buying an additional $600k of property, which also means much less future cash flow in retirement? It’s almost never just about the difference between ordinary and cap gains tax rates. Make sense?

  9. James Hall

    Maybe I do not understand all this 1031 stuff correctly…

    Assuming you break even on a sale (your adjusted bases = sales price) you paying cap gains on only the recaptured dep.

    If you trade-up instead of sell, your basis in the property acquired decreases by the recaptured depreciation that you would have paid cap gains on. Thus in that year you are increasing the amount of income paid at the higher ordinary income tax rates by reducing your dep deduction in the new property.

    If instead you sold the property and paid the 15% to 20% cap gains (and assuming you bought another property that had a depreciable bases > your adjusted bases in the old property) you would decrease the amount of income taxed at the higher ordinary income rates (25% – 39.6%) by not reducing your dep deduction in the new property.

    For a new investor starting in the 25% tax bracket (who is determined to either sell or exchange now) wouldn’t it be better to pay the 15% cap gains now and utilize the full depreciation deduction in the new property while they are in the low ordinary income tax rates rather than waiting 30 years down the road when they could find themselves in the 39% ordinary income tax bracket and having to pay 20% on the gains they differed that they could have paid only 15% on?

    It would be interesting to see how much total tax (ordinary and capital) a person would pay during their lifetime if they sold their properties along the way rather than exchanging them and differing the gains until they were in a higher (or highest) ordinary income and cap gains tax brackets.

    Thanks for your time and advice

  10. Jeff Brown

    Hey James — I think I see the missing piece now. You might be putting the accent on the wrong syl-LA-ble. 🙂

    It’s not necessarily about comparing ordinary and cap gains rates. It’s about all the factors involved, many of which you nicely outlined. I spend much of my time with investors doing as you suggest, which is talking them out of 1031s. However, at some point the tax pain becomes a gigantic hindrance to the overall, long term plan. The common denominator with most investors is that they realize at some point that their after tax retirement income is what’s important, not their net worth. We’re mostly if not totally on the same page. Pay the cap gains tax as you go, and start anew each time you ‘move up’. It’s just that it’s not always possible to do that in the real world.

    Take the period 2000-2005 as an example, in an exceptionally appreciating market, that’s also high priced. When we add massive profit to the vastly reduced adjusted cost basis (depreciation) the tax, even at the cap gains rate can be bloody. In San Diego’s market we faced that for a couple generations. It’s a nice problem to have, but doesn’t have an especially good ending after multiple exchanges over a few decades. The kids come out great, just not their parents if they sell.

    Make sense?

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