Mortgages & Creative Financing

How a 1031 Exchange Can Make You Millions

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Let’s take a look at two different investors who bought and sold properties over a 25-year span.

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The investors in both scenarios start with the same amount of money ($50,000), buy the same property (a $250,000 deal, 2nd column below), have the same growth (5% equity growth each year, reflected in the 3rd column below), and reinvest their profit (4th column below) plus their previous down payments as a 30% down payment on their next deal (5th column), but each ends up with a very different amount because of the taxes.

(For simplicity, I do not include closing costs, depreciation, loan paydown, cash flow, or other obvious sources of income and expenses in this diagram. This is simply to illustrate a point.) See below.

Investor #1 purchased a $250,000 property with his $50,000 down payment. After five years, he sold it for $319,070.39. He was able to use the entire profit and his equity he'd built thus far, to put a 30% down payment on his next deal. This continued for 25 years with no tax due, because he continually used the 1031 exchange. Now let's take a look at the numbers for Investor #2, who chose not to use the 1031 exchange. See below.

After 25 years, Investor #2 ended up with just less than $2.5 million. Although this is still a respectable sum of money, notice that this investor trails Investor #1 by more than $1,000,000! This is because Investor #1 was able to put the government’s money to work by using a 1031 exchange, helping him build greater wealth.

Now, what happens to Investor #1 at the end of year 25? After all, the 1031 exchange is simply a method of tax deferral, not tax avoidance. Or is it? Let’s talk about that next.

Related: The 10-Step Process to Perform a 1031 Exchange

The 1031 Exchange End Game

In our examples, Investor #1 ended year 25 with $3.8 million, while Investor #2 ended with $2.4 million. But what happens after that? Typically, there are two common scenarios for any real estate investor when they are done with their investment career.

1. Cash Out

Some investors decide to exit the real estate game entirely, cashing in their chips and walking out the door. In other words, they decide that they will pay the IRS what they owe after selling all their properties. However, at this point, they are not simply paying the taxes on that final property’s profit but (put very simplistically) on all the properties for which they have ever used the 1031 exchange. Because the “cost basis” of a property is carried forward on every deal, that final tax bill will likely be exceptionally large.

Keep in mind that if you opt for this end game strategy—cashing in your investments and paying the tax—you will still likely have significantly more income than if you had paid taxes each time you sold a property.

2. Die and Pass It All On

That’s right, many investors simply choose to hold their properties until the day they die, and to pass the properties on to their heirs. The benefit of this approach is that current inheritance laws allow the heirs to receive the property on a “stepped up basis,” which means the tax consequences virtually disappear.

For example, let's say the adjusted basis on a property, after numerous 1031 exchanges and lots of time, is $200,000, and the property is worth $3,000,000. If the owner sold the property five minutes before dying, they would owe taxes on the $2.8 million in gain. But if the estate passes to the investor's heirs, the basis is automatically bumped up to the fair market value, or $3,000,000. The heirs could then sell the property and pay little, if any, tax. Of course, there are special rules and fine print that accompany this (especially for the exceptionally wealthy), so be sure to talk with a qualified professional about your estate planning!

buy-first-property

Related: 4 Rules of 1031 Exchanges Every Investor Should Know

Understandably, not every investor wants to hold on to properties until they die. I know I don't want to be dealing with tenants when I'm 40 years old, so being a 100-year-old landlord is absurd! So how does one get around this?

You do it by trading up into properties that are significantly easier to manage! For example, perhaps you could 1031 exchange your equity into a multimillion-dollar shopping mall, as part of a syndication with hundreds of other investors. Or trade it into a NNN lease commercial investment where the tenant pays everything and you sit back and collect a check.

There are hundreds of ways to make money with real estate, so simply trading up to a more passive method sounds pretty good to me.

[Editor’s Note: We are republishing this article to help out our newer readers.]

Do you use 1031 exchanges in your real estate investing? Any questions?

Leave a comment below!

Brandon Turner is an active real estate investor, entrepreneur, writer, and co-host of the BiggerPockets Podcast. He is a nationally recognized leader in the real estate education space and has tau...
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    Larry Ott Investor from New Albany, Indiana
    Replied over 2 years ago
    I have 35 acres which includes my personal residence, have owned it for 30+ years. I am being forced by the county to sell 6 acres of my property for a new road that is going to be constructed…….. Are the 1031 laws applicable if you only sell a portion of the property?
    NA Henson Specialist from Austin, TX
    Replied about 2 years ago
    Yes, more than one way to get this done. Best to find a target property before relinquishing current property. IRC section 1031 deadlines can cause an exchange to fail. Another way to defer capital gains is to use the installment sale method. IRC section 453. Both section 1031 and section 453 require the use of 3rd party intermediaries. In addition, a section 453 installment sales can be joined with a “monetization loan” for the full value less the intermediary’s fees. (To see explanation of this method web search IRC 453 & monetized loan. Your search should even pull up the IRS Letter Memo from 2012? explaining why this is one valid method to utilize. There are several firms to use for this. Monty Henson Active REI Asset Protection Expert Licensed Attorney Austin, TX
    David Fisher
    Replied about 2 years ago
    If you are talking about a proprietary trust based on Section 453, its a great opportunity. If you can complete a 1031, do so but if the 45 and 180 day periods are a concern, Section 453 may make more sense. Also, the Section 453 trust can be used when a property owner would like to sell and retire but doesn’t want more real estate. Section 453 can still defer the capital gains tax, state tax, depreciation recapture and the Obamacare tax which will provide the property owner with a larger retirement income than if he paid those taxes first. One potential problem with a 1031 is that when you sell in a sellers market, you may have to buy high in the same market. What if you could sell the property today, defer taxes today and take all the time necessary for market conditions to become more favorable to the client. If that is 2,3 or 4 years, it doesn’t matter. There are other opportunities for Section 453 to defer taxes when a 1031 isn’t appropriate or can’t be completed. Section 453 is the next generation of 1031 exchanges.
    Susan O. from Fresno, California
    Replied about 2 years ago
    a lot of people say you eventually trade up to a NNN lease and then tenant does everything but I’ve heard some horror stories where a Net tenant does lots of damage to property or bellies up bankrupt and then you’re stuck with a 6 month vacancy
    David Fisher
    Replied about 2 years ago
    There can be problems so you have to be careful. Some of the these programs in the past have worked really well. But there is a lot of money to be made by the real estate sponsor using these programs, so you have to dig into the actual deal. For example, lets say you find a program that is paying a higher return than others. What has happened in the past, is that the real estate sponsor would take an interest only loan for say 5 years so they could pay a higher return but quite often, they were unable to refinance for a number of reasons and the property basically fell apart. I saw situations where the individual that invested in the property may have received back .30 on the dollar but ultimately still had to pay taxes based on the original basis so check out the actual property info. I may be a bit biased but I believe that Section 453 is more flexible and possibly a better option than Section 1031.
    Kevin Hom
    Replied 7 months ago
    There's actually a 3rd exit strategy: move into the property. You need to own the property for 5+ years and live in it for 2+ years, but this will qualify it as your primary residence and give married couples a $500k exemption and singles a $250k exemption.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 7 months ago
    Great catch Kevin Horn. Conversion of an investment property in to your primary residence does not create a taxable event. So as long as you own that property you'll never pay the tax. And you're right, if you sell down the road you will get to take advantage of the primary residence exclusion. Unfortunately you'll have to prorate the gain between periods when it was your primary residence and periods when it was rented. So you'll still have to pay some tax. And you do have to recapture depreciation. But it's still a great option to have to mitigate some of those taxes down the road. Kudo's for recognizing it.