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!

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?

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.

1. Allison, you should explain to people how 1031s work and what the restrictions are…

• Nah. There are plenty of articles on that topic already. And there is a link embedded in the article for that purpose.

• Hi Adam: John is right, there are quite a few articles on our site regarding 1031 exchanges. I am happy to point you in the right direction.

I’d highly recommend:

Hope that helps! Let us know if you have any questions.

**And sorry for the confusion. This post is actually by Brandon. I uploaded it for him and neglected to change the author. Oops!

2. 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.

• Agreed. We own the fruits of our labors

• 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.

• 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. 🙂

• One can invest in Peshawar or anywhere else by trading one thing of value for another. To keep it simple, trade gold for a property collect rent in silver. Currency is just an IOU. I cannot work for food, housing, car, etc. I trade work for cash, then trade cash for stuff. It is not the government’s doing at all.

3. 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).

• ive Been pondering th e exact same issue. Looking to simplify as I head into retirement

4. 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.

5. I’m interested in the Estate Planning portion/passing the properties on and increasing the basis for my heirs portion. Are there any articles here I should check out?

6. 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.

• 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.

• 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.

• Our 1031 exchange involved new construction. We identified the property really quickly because we knew what and where we wanted to purchase. The problem was that the construction dragged out at least 4 months after they said they were going to complete the building. Luckily we were able to pressure the builder to close with a Temporary Certificate of Occupancy. We literally closed on the property with about 3 days to spare on the timeframe. The 1031 exchange company was very helpful throughout the process. So just some food for thought! 🙂

We are very happy with the purchase so far as we were able to exchange some very old rentals that needed extensive rehab into properties that are turnkey. The rents are higher and the tenants of better quality as well. So, less drama, less maintenance. Would I do it again? Sure, it just depends what you want to own and what makes sense. For us, getting older, having properties that require much less work was key to our decision.

7. How doesn’t one do a 1031 into a syndicated deal?
Thanks!

8. 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.

• I agree with you that an article like this is incomplete if it doesn’t compare the strategy of leaving the original property in place but using the excess equity to finance your next acquisition. I don’t do “cash out refi” per se but I do close on new buildings with zero new money down by providing the bank a 2nd lien on an underlevered existing property I have.

• Two reasons.

1. Sometimes you want to remove a property from your portfolio.

2. Leverage. Use it to excess at your peril.

9. Ramaiyer Ramesh on

Is there any one who has moved their 1031 exchanged properties to a trust and pass it on to those take over the trust ?

10. In hot markets, 1031 exchanges may not be the best option but did hear about the installment sale treatment under section 453 which may be a better alternative. Anyone ever use this?

• 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!

• Section 453 is the next generation of 1031 exchanges. No 45 or 180 day periods or any of the other 1031 limitations. Sell a property today, defer taxes today and buy any type of property at any time in the future.

You can also sell a property and if you would like to retire, you can still defer taxes without buying more property. You can also defer the capital gains tax, state tax and the Obamacare tax when selling a high end residential property. You can defer your taxes with proper estate planning to your heirs.

Say that you’re selling more than one property and would like to buy another property, there are no time constraints.

11. 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”? 🙂

12. 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?

13. Hello,
While 1031 shows its benefits.
Has anyone done investments from Roth IRA and reinvested and vested out from that route after 25 years? What would that look like? Curious to know.

Thanks.

14. Careful Brandon. a young Mick Jagger said he couldn’t imagine being a 40 year old Rock star still playing. He’s somewhere over 70 now.

15. 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.

• James, I hope you don’t mind my comment. There is a proprietary trust based on Section 453 that will allow you to defer taxes for as long as you would like. There are no 45 or 180 day periods. I work with a number of brokers all over the country that sell high in a sellers market and then have unlimited time to buy another property. For example, a real estate broker can sell a property today, defer taxes today and then have unlimited time to wait for market conditions to become more favorable to buyers before buying. If that is 2,3 or 4 years, thats fine.

Also, we can defer taxes for the rest of your life and that deferral can be passed on to your heirs. Everyone wins but Uncle Sam. Best wishes.

16. 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.

17. Does anyone know if I can sell a duplex with a property, then buy a note with the proceeds? My research tells me know, but I wanted to get some feedback that may tell me I’m mistaken.

• Needs to be real property in a 1031 exchange. A note does not qualify

18. i dont know about other markets, but the Seattle market is hot. i frequently review other peoples deals and see that the seller paid a premium for the newly acquired property in a 1031 tax deferred exchange that is greater the the 15% capital gains tax rate. that indicates to me that the brokers are churning clients at the client’s expense or the brokers lack the technical skill to do proper financial due diligence with discounted cash flow analysis and quantitative analysis. the clients could have disposed of the asset. paid the capital gains tax and be slightly better off without the headache of the a 1031 tax deferred exchange or reverse exchange.

• Michael, obviously I don’t know the specific situations you are discussing but by using a proprietary trust based on Section 453, your clients can sell their property, defer taxes and have all the time needed to buy another property. In a hot market like Seattle and elsewhere, you can sell and defer taxes today and wait, if appropriate until market conditions are more favorable to buyers. If that is a couple of years, that’s fine. Best wishes.

19. 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?

20. 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