Don’t Pay Taxes on Your Capital Gains (Part 2): 1031 Exchanges

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In last week’s article, we explored the anatomy of a 1031 exchange and the government’s reasoning for creating such a powerful tax-saving tool. This week, we’ll look at a hypothetical example such that we may more clearly understand how a 1031 exchange works. We’ll close by addressing some common concerns. Let’s get to it!

Ted’s First Investment Property

Ted understands the advantages or real estate investing and does everything he can to acquire his first investment: a nice little income property located at 101 Main Street. After careful analysis, he purchases it for $400,000 and pays $8,000 in acquisition costs. Over the next year, he operates the property as a rental—this is crucial because simply acquiring property for the sole purpose of resale does not qualify for a 1031 exchange. During this time, Ted replaces the roof and makes some other capital improvements totaling $15,000. He also takes a depreciation tax deduction of $5,333.

At the end of the year, Ted decides to sell his property for $475,000. So, what is his capital gain? First, we must calculate the adjusted basis. Add the original cost ($400,000), acquisition costs ($8,000), and capital improvements ($15,000) and subtract depreciation ($5,333) to come up with the adjusted basis of $417,667. To calculate his capital gains, subtract the selling costs ($28,500) and adjusted basis from the selling price to come up with $28,833 [=$475,000 (sales price)-$417,667 (adjusted basis)-$28,500(selling costs)].

How Ted Avoids Paying Taxes

Ted doesn’t want to pay taxes on his gain of $28,833, and he doesn’t have to if he properly performs a 1031 exchange. He starts the process by identifying a replacement property at 505 Clark Street that he can purchase for $500,000 (he can choose up to three replacement properties; that way if one doesn’t pan out, he has two back-ups available). Before he sells his original property—101 Main Street— he sets up the exchange with a qualified intermediary. The intermediary holds the net proceeds from the sale of 101 Main Street until Ted closes the sale on his replacement property, 505 Clark Street. Keep in mind, however, that the exchange must be completed within 180 days after the sale of the original property. Therefore, it’s a good idea to plan the exchange well in advance and to utilize the expertise of someone experienced in performing such exchanges.

Ted completes the exchange and purchases 505 Clark Street for $500,000. What is the new basis? Assuming that the acquisition costs were $8,750 and knowing that the deferred gain is $28,833, the new adjusted basis is $462,417 [=$500,00 (purchase price) – $8,750 (acquisition costs) – $28,833 (deferred gain)].

What’s the Big Deal?

While the above is simply a hypothetical example, realize that people have deferred much larger gains in real life. It San Diego, it is not uncommon to find a property owner who purchased an building ten years ago for $500,000 only to sell it today for $3,000,000. You can imagine how steep the taxes on those capital gains might be were it not for the 1031 exchange.

Some of you may be shaking your heads thinking, “won’t Ted have to pay taxes on his gains eventually? He’s just delaying the inevitable. Why not just pay the taxes now?” To address the first question, Ted may never have to pay taxes. There are ways he could transfer the property to loved ones tax-free. To understand the answer to the second question is to understand the “Time Value of Money (TVM)” theory. The theory suggests that money today is worth more than money tomorrow because it can be invested and, thus, earn a return. The money Ted would have paid out in taxes will instead be reinvested. Understanding this, it becomes easy to see how blowing off Uncle Sam for as long as possible bears sweet financial fruits.

Understand the 1031 exchange and use it to increase your net worth.

Happy investing!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.