Real estate investors can use 1031 exchanges to save millions through deferred taxes. A 1031 exchange allows an investor to sell a property and reinvest all net proceeds in order to defer all capital gain taxes.
For example, capital gain taxes on net proceeds of $400,000 would be $140,000, reducing your potential reinvestment capital to $260,000–a sizable decrease. Using a 1031 exchange, investors could defer that $140,000 in taxes as long as they reinvest the entire gross equity–$400,000.
Long-term real estate investors often save millions using 1031 exchanges. Avid real estate investor Brandon Turner at BiggerPockets wrote a book titled Rental Property Investing Made Simple. Below is an excerpt from his book, which goes into detail on the best ways to profit from 1031 exchanges.
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.
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.
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.