Mastering physics is certainly not a requirement for building wealth. That said, it doesn’t hurt to understand that a snowball rolling downhill can be expected to gain both mass and momentum. Real estate investments centered around 1031 exchanges are designed to act in much the same way.
Often misunderstood because of complicated IRS rules, investments that use a series of 1031 exchanges should grow larger because profits that otherwise might be lost to capital gains taxes are not plucked along the way. Instead, the taxes are deferred until the investor is ready to cash in and not make further 1031 exchange investments. This could take place after one 1031 exchange or a series of exchanges spanning several decades. In the best of all worlds, it’s done when the real estate investor is in a situation that makes cashing in beneficial. Let’s cover an example — after going over some basics.
Understanding a 1031 Exchange
A 1031 exchange is basically a swap of one investment property for another. There isn’t much else basic about it, however. There are several IRS rules to be followed to ensure the exchange qualifies. Otherwise, the tax benefits may be lost and capital gains taxes will have to be paid for the same tax year that the original investment property was relinquished.
Among the most important rules to understand are that the new investment property must be of equal or greater value than the relinquished property, and it must meet the IRS definition of a “like-kind” property. There are numerous other rules, as well. That’s why relying on the expertise of a partner such as Precision Global Corporation is often recommended.
A Formula for Success
While it’s OK to skip the physics lesson here, math will definitely help illustrate how 1031 exchange investments build wealth over time and with each transaction. For our fictitious example, let’s look at two investment scenarios — one in which 1031 exchange investments are used, and one in which capital gains taxes are paid each time an investment property is sold. (We’ll ignore recapture taxes, depreciation and other factors in the interest of simplification. The intent here is to highlight the power of compounding profits.) Let’s also presume the following:
- A 20 percent capital gains tax bracket
- A $4 million initial investment in a property
- A 25 percent return on the first property investment, followed by gains of 50 percent and then 100 percent on subsequent investments
In the scenario using a 1031 exchange, a 25 percent gain on the first investment yields a $1 million profit — for a total net worth of $5 million. A 50 percent gain on the second investment raises that to $7.5 million. Doubling it with our hypothetical third investment makes the total $15 million.
Under the second scenario, there’s also a $1 million profit on the first investment, but without using a 1031 exchange, $200,000 in capital gains taxes are paid in the same tax year. This reduces the capital for the second investment to $4.8 million. A 50 percent gain — that’s $2.4 million — brings the total to $7.2 million, but $480,000 lost to capital gains taxes leaves the total for the third investment at $6.72 million. Doubling that for the gain on the third investment brings the total to $13.44 million, but paying 20 percent in capital gains taxes on the $6.72 million profit reduces the remaining balance to just below $12.1 million. Compare that to the first scenario — $15 million would be available for a fourth 1031 exchange investment — and it’s easy to see how using 1031 exchanges can result in investors having more buying power over time.
This is just a fictitious example to illustrate how effective using a 1031 exchange strategy can be. To learn more about 1031 exchange investment opportunities, contact us today.