When selling real estate in America, you can either sell the property and pay taxes on the capital gain (i.e. profit) or you can defer the taxes by rolling all of the proceeds of the sale into a different property, which will be considered to have the same basis* (bookkeeping value) as the property you just sold. Doing this is called a 'Section 1031 Exchange' ('1031' for short), as the rules governing it are found in IRS Code section 1031. The details of those rules aren't important for this post; I'm going to try and figure out how differently things would end up in doing a 1031 exchange versus not doing one.
There are going to be a lot of assumptions in this one, so buckle up.
* The basis is the amount you bought a thing for, but it can be adjusted over time by depreciation, capital improvements, etc.
Situation 1: Doing the 1031
Tom takes all $150,000 from his old property and uses that as a 20% down payment on a new property. That means he can afford to buy a property for $750,000 because 20% of $750,000 is $150,000. (You can calculate like so: $150,000 ÷ 20% = $750,000.) He'll need to borrow $600,000 to cover the rest, and he'll have to pay that back when he sells the property. His new property's basis is $60,000 (bookkeeping value carried over from the old property), which is what he transferred with the exchange, and after 14 yeras that will have depreciated down to $30,000. Any amount over this basis, he'll have to pay taxes on at a 40% tax rate. So now we need to know how much the market value of the house will appreciate over the 14 years. 14 years = 14 x 12 = 168 months. First things first, make sure the calculator is using 12 Payments per Year. N: 168 (Tom will sell the new property after 14 years) I/YR: 4 (The new property experiences 4% market-value appreciation) PV: -750,000 (The new property's initial value is $750,000) PMT: 0 (The new property breaks even on a month-to-month basis) FV: (This is what I'm trying to find) After the 14 years, Tom will sell the house for $1,311,782.19. First off, Tom has to pay 10% to sell the house (real estate agent commissions, fees, etc.), leaving him with $1,311,792.19 - 10% = $1,180,603.97. Sales costs are deductible when calculating capital gains (so he doesn't have to pay taxes on this 10%). Then, he has to pay off his $600,000 mortgage, leaving him with $1,180,603.97 - $600,000 = $580,603.97. Mortgage repayment is not deductible when calculating capital gains (you do get taxed on the $600,00 of income used to pay off the mortgage). Then, he has to pay taxes. He pays 40% of the gain above his basis, which is now $30,000. So Tom's capital gain is $1,180,603.97 - $30,000 = $1,150,603.97. 40% of that amount is $1,150,603.97 x 40% = $460,241.59.Subtracting taxes from his sales proceeds, Tom is left with $580,603.97 - $460,241.59 = $120,362.38.
Situation 2: Paying the taxes instead of exchanging
Tom takes the $150,000 profit from his old property, pays 29.3% in taxes, and uses the rest as a 20% down payment on a new property. After taxes, Tom is left with $150,000 - 29.3% = $106,050. That means that his new property is worth $106,050 ÷ 20% = $530,250, and he's borrowing $530,250 - $106,050 = $424,200, which he'll have to pay back when he sells the property. His new property's basis (bookkeeping value) is $530,250, since he's buying it without doing an exchange, and after 14 years it'll be half of that, or $265,125. Any amount over this basis, he'll have to pay taxes on at a 40% tax rate. N: 168 (Tom will sell the new property after 14 years) I/YR: 4 (The new property experiences 4% market-value appreciation) PV: -530,250 (The new property's initial value is $530,250) PMT: 0 (The new property breaks even on a month-to-month basis) FV: (This is what I'm trying to find) After the 14 years, Tom will sell the house for $927,430.01. First off, Tom has to pay 10% to sell the house, leaving him with $927,430.01 - 10% = $834,687.01. Then, he has to pay off his $424,200 mortgage, leaving him with $834,687.01 - $424,200 = $410,487.01. Then, he has to pay taxes. He pays 40% of the gain above his basis, which is $265,125. So Tom's capital gain is $834,687.01 - $265,125 = $569,562.01. 40% of that amount is $569,562.01 x 40% = $227,824.80.Subtracting taxes from his sales proceeds, Tom is left with $410,487.01 - $227,824.80 = $182,662.21.
Closing thoughts
I'll be honest - I didn't expect the pay-taxes-now scenario to be so obviously preferable to the 1031 exchange. In the real world, it's likely that if Tom knew what he was doing, he could buy a new property that would generate income each month, he could get a loan that amortizes, and maybe he'd buy in an area that had higher appreciation. Even then, though, I'm not sure he could make up such a significant difference. If the Exchange property could average more than $371 per month in extra cash flow, it would do better than the non-Exchange property, but that might be tough to pull off. The reason this result surprises me is that I know a lot of people who have made a lot of money in real estate over the decades, and they all swear by 1031 exchanges... but on its face, it looks to me like Tom would be better off just paying the taxes and reinvesting the balance. In the end, it looks like transferring a $60,000 basis into a $750,000 house was the biggest difference - paying taxes on profits above $30,000 instead of profits above $265,125 meant that the capital gains taxes at the end were so high as to eat all of the other benefits and more. It's possible that using consecutive 1031 exchanges would be a good way to buy bigger and bigger properties, which have more and more doors and can therefore generate more and more cash flow on a month-to-month basis. If I were to do this, I think I'd want to avoid getting a huge tax hit at the end, either by never selling, selling in some way that doesn't realize my entire capital gain all at once (lower capital gains generally mean lower tax rates), or by finding some way to 'reset' the basis. Additionally, the assumption in this post that the new property generates no cash flow could affect the results significantly, but a specific situation in which the Exchange property is a duplex and the non-Exchange property is a single-family house might be enough to make up the difference in net revenue after the end sale. What do you think? Have I missed anything important? Have you ever done a 1031 exchange? If so, how did it work for you? Would you do it again? Let us know in the comments!
