How a 1031 Exchange Can Make You Millions

by | BiggerPockets.com

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

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.

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

Leave a comment below!

About Author

Brandon Turner

Brandon Turner (G+ | Twitter) spends a lot of time on BiggerPockets.com. Like... seriously... a lot. Oh, and he is also an active real estate investor, entrepreneur, traveler, third-person speaker, husband, and author of "The Book on Investing in Real Estate with No (and Low) Money Down", and "The Book on Rental Property Investing" which you should probably read if you want to do more deals.

29 Comments

  1. Good article, I have used 1031’s and sure hope they do not go away with tax “reform”.

    The only exception I take to the article is the phrase, “This is because Investor #1 was able to put the government’s money to work by using a 1031 exchange”.

    Actually, the investor is putting THEIR money to work. The notion that gov’t inherently has a right to an individuals money is misguided. We all should remember that. That money belongs to the investor… they only figured out how to hold on to it.

    • David Weintraub

      Actually, the government creates an economic system for you, that you stand to profit in. Can you go flip houses or invest in rentals in say, Peshawar? If so, maybe you should!

      Yes, you earn the money, but the government actually CREATES the money.

      So while we like to have this grand idea that we’re all amazing, and we make all our OWN money, we do so within a system that is created, protected, and furthered by the US Government and your tax dollars.

      • David,

        I am sorry, but that is just wrong.

        The Gov’t in fact does not CREATE money, they PRINT money. There is a difference. The money they print has value because WE trust it and use it as a means to exchange goods and services. The Gov’t also does not CREATE an economic system, they REGULATE our economic system. People created the economic system we know as “Free Enterprise”… that was NOT created by a government. Yes, our Gov’t does allow free enterprise to exist, while some governments do not. That is certainly a good thing, but it does not make Gov’t the creator of that system.

        Of course, we all benefit from certain rules and regulations that occur in our society. I am not promoting anarchy, but I am also not willing to credit gov’t with all the prosperity we may enjoy.

        • David Weintraub

          Is your name on the money?

          Yes, individuals created an economic system made possible by our system of governance, and kept afloat because of the government.

          There’s no way around it, Rand. 🙂

  2. Christopher Smith

    I am in the process of attempting to do this now.

    I have several West Coast SFRs with well over 100% appreciation in them (and some Midwest properties as well) and would like to some day consolidate those (perhaps via 1031) into one or two larger activities such as multi-family or a commercial property. I don’t manage any of my SFRs, and they are all very strongly cash flow positive, but it would still be nice to pick up something to consolidate these activities with even stronger cash flow yet and little to no administrative issues (e.g., maybe a gold standard triple net lease arrangement).

  3. James W.

    Nice article. Thanks.

    I am selling a property and am faced with a huge capital gain tax.

    I considered 1031 for a long time but one problem is, i need to find new properties that are worth investing. Deals do not come on demand, they come when they come… but there’s only a limited time to find a property after 1031.

    The second problem is, if you’re going to defer all taxes, you have to defer realizing all profit also. We dont get to see the money till we pay the tax – now or later.

    And lastly, the third option of die-and-pass-it-on has the same problem that you as an investor never see the profits. That may be a (is a) a serious consideration for many investors. Passing it on has its merits, but all the efforts in life may be no use to many people if they never get to use the profits for themselves.

    • James, the way I look at it, in a way you are benefiting from the profit. In theory, you are moving up to a better property with better cash flow, better tenants, and lower maintenance. Yes, in practice, the same rising market that elevated the value of your relinquished property has made finding a replacement property difficult. That is when you may have to consider other areas, or ways to add value to a replacement.

  4. jEFF d.

    It should be noted that it’s usually more than 15% tax you are “deferring” with a 1031 exchange. You have to account for the depreciation you’ve taken along the way also – and longer you’ve owned something, the worse that is. And if your state charges tax on the gain, there’s that too. So in my state, having just done a big 1031 exchange (2 properties into a 1 bigger one), I deferred about 30% in taxes. A substantial amount. And yes, by not having to pay that to the IRS, you now have much bigger amount of down payment for the next one.

    The flips side should also be noted. 1031’s are precarious…….esp if you’re shopping for an apartment building. You’ve got 45 days to identify 3 possible properties to exchange into. And yes, in theory, if one doesn’t work out, you’ve got a couple back ups. Well here is the reality. Things take forever in the commercial world. Shopping for an apartment building isn’t like shopping for a house. There’s just a lot less of them out there for sale. So it takes a while just to find one, much less 3. It takes forever to negotiate a deal and get it under contract. Unlike a day or two in residential from offer to acceptance, it might be a week or two with commercial. And a month or so waiting on the appraisal, and other inspections. And you’re also waiting on the bank financing. And the seller may need an extension of time because he is in same 1031 predicament and is frantically trying to find something and get it under contract to meet his own 45 day deadline. So it could easily be a couple months before you even know for sure if that one you’ve locked up is going to happen. And at that point, if for whatever reason it doesn’t work out, now you’ve used up 2 months of your 6 months to close time and the the other 2 backup properties have probably been put under contract by someone else by then. Then you are kind of screwed.

    The 45 to identify / 6 months to close time deadlines are fine for residential. But really tight for commercial. And there’s a cost attached to having to rush into something that may not be the best deal versus having the breathing room to take as long as needed to find a “good buy”. And if you really want to split hairs, I supposed if you did the math, considering that syndrome of being under the gun and being forced to buy a a higher than otherwise price, in some cases it could actually be financially advantageous to just pay the tax on what you’re selling, and take the time to find a really good deal with great upside instead.

    • Jerome Kaidor

      1031’s are precarious…….esp if you’re shopping for an apartment building. You’ve got 45 days to identify 3 possible properties to exchange into

      *** Indeed. In the current environment, I needed to do a 1031- I opted for a *reverse* 1031, where I bought the replacement property FIRST, and afterwards sold the (very hot, and easy to sell ) relinquished property. The exchange was not cheap. Basically, the exchange coordinator formed a corporation which bought the new property. That corporation charged me a token rent, and the clock started ticking. When I sold the relinquished property, they dissolved the corporation – I think.

      It wasn’t cheap. I think it cost me about $8K more than an ordinary 1031. But it insured me against an enormous tax liability.

    • Brian K Buff

      I agree, also end of life scenarios rarely play out as we anticipate. If you should need long term nursing care late in life, liquidating your assets becomes an unwelcome reality. Adding in years of profits and reduced basis due to depreciation would make this a very costly endeavor. Ideally, the investor would have the cash flow from a lifetime of investing to cover off on any healthcare related expenses to avoid any solvency issues, but at $250 per patient day, it can get expensive fast.
      Another issue would be divorce or civil lawsuits that could force the investor into liquidating long held assets. this could get very costly and should be considered fully.

  5. Charles A.

    It’s hard for anyone to convince me 1031 is a superior strategy to cash out refinance.
    I will do the debate with anyone here openly.

    Jeff D above has stated many of the often overlooked dangers of the 1031 exchange.
    They are not negligible.

    With a cash out Refy strategy,you get all the benefits of a 1031 exchange without any of the headache and deadline pressure.
    Find the bigger next deal on your own time.
    And you still continue to build equity in your old property with loan pay down and cash in on any future appreciation.
    Once you 1031 a property,it’s gone forever…with any future equity build up.

    • Maggie Vineyard

      Hi Natalia-
      Did you receive any responses on your question? I have not heard of this but am very curious to know more. I have an upcoming exchange in January and would love an alternative. Shopping for multifamily in this market with 45 days is very difficult!

  6. Charles Chapin on

    I enjoyed the article, a good intro to 1031 exchange and why it’s great. But I laughed out loud when I read “I don’t want to be dealing with tenants when I’m 40 years old.” Half a minute later my wife was reading over my shoulder and laughed at the same spot :-).

    But seriously, having done a couple of 1031 exchanges, it’s definitely good to consider their pros and cons. The cons have been better explained in the comments than they were in the article.

    Aside: hey Brandon, what is a “third-person speaker”? 🙂

  7. Kimberly Ellis

    When looking for the next deal to use the 1031, are there limitations on location? Does it need to be the same state where the sold property is, or are you able to look elsewhere? Are the 1031 regulations the same everywhere, or do they vary by state?

  8. James W.

    You have to pay the tax eventually any way. So one can simply pay the taxes and move on. Without worrying about finding deals at a gun point. It rarely happens you sell a great property and find a great deal in this timeframe. So its a constant headache.

    Anything we buy or sell has taxes on it, this is no different. Its the cost of doing business.

  9. Ritch Bonisa

    Someone should discuss how the improvement or construction payments are dispersed on these. The criteria for paying out funds, who gets direct payment, who authorizes said payments, the time frames between work and payment, who is responsible for funding of improvement costs in there interim, etc.

    Possibly even some good ideas on “work arounds” when sub contractors are not paid in a timely manner. Who needs to be the General Contractor, etc. These would all be good things for us to know.

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