Free Money
Using Section 1031 to defer the payment of Capital Gains taxes is like getting the free use of the IRS’s money for as long as you own the new investment property that you bought with it.
Free Money Times Four
And not only that, but you can use the IRS’s money as just the 25% down payment, borrowing the other 75% needed for the purchase, and it’s like Free Money times four.
Free Money Times Thirty
And if you hold your investment for ten years, and do another Section 1031 Like Kind Exchange, you could end up owning real estate with a market price of 30 times your initial investment.
And understand, the money that enabled you to do the initial investment, the down payment, wasn’t even your money to begin with, it was money that you owe to the IRS, but which you might never have to pay.
It has become Free Money Times Thirty.
This is the power of Section 1031.
Let’s look at the scenario.
Summary
If you sell an investment property, and have a $250,000 profit, good for you.
But it creates a $50,000 tax liability. (That’s just the federal Capital Gains tax of 20%, but we use this number as an estimate, it could be much higher with state and federal combined.)
However, you can engage in a Section 1031 Like Kind Exchange and keep the $50,000 instead of sending it to the IRS.
You then use the $50,000 as a down payment, borrowing another $150,000 and you buy a $200,000 rental property.
In ten years, the FMV of this $200,000 property increases to $358,000 and the loan balance decreases to $120,000.
So you have equity in the property of $238,000 which you free up by selling the property, and then doing a second Section 1031 Exchange. You use the $238,000 as a down payment, borrow another $715,000, and buy a multi-family property for $950,000.
The IRS’s $50,000 is now controlling $950,000 of rental property, and it is in your name!
And the $950,000 property is increasing in value by more than $57,000 each year just by sitting there, not to mention the cash flow!
Let me walk you through it.
Reading time: Four minutes, 20 seconds.
Tax Liability
The first thing you have to understand about deferring taxes on your Capital Gains (your profit) is that when you do, the money you are keeping, and then using to invest in new projects, is money that, in effect, is not really yours.
And it’s not borrowed money either. It’s better than borrowed money because you don’t have to pay interest or make monthly payments.
Really, it’s money that you will eventually owe to the IRS, but you don’t have to pay until you are ready to pay, and you might be able to create a situation where you never have to pay.
In other words, you are using the IRS’s money to invest in real estate.
And they know it, and they are fine with it, and they want you to do it.
In fact, they require you to do it. That’s why Section 1031 exists.
And it gets even better!
You are also using the IRS’s money to qualify to borrow three times that amount, ending up with an investment fund made up entirely of other people’s money, the IRS’s 25% and the lender’s 75%, but managed by you and used to build your own real estate portfolio.
Your borrowing power and sources of funds might be different, but I will use the 25-75 ratio as the average, because that is what I have always done. And if you are a knowledgeable real estate investor and businessman, or become one, the lender will treat you the same way, as a low-risk 75% borrower.
Tax Deferral
In our example, we will be doing a Delayed Exchange, not a Reverse Exchange or a Construction Exchange. Those are covered in other sections, see the tabs above.
A Delayed Exchange is one that will conclude within 180 days of the date of the sale.
Imagine, for the purpose of comparison, that you sell a business or investment asset, such as a Duplex, and make a profit of $250,000. You will incur a Capital Gains tax liability of $50,000 which you will send to the IRS.
This transaction will probably put you into the 20% capital gains tax bracket.
Part of the profit will be identified as pure Capital Gain, the difference between what you paid for the property and what you sold it for, taxed at 20%, and part of the profit will be identified as Depreciation Recapture, paying back to the IRS a percentage of the Depreciation that you claimed on the property while you owned it, up to 25%, but to keep the Example clear and understandable we will just use one figure of 20% on all of it.
So, .20 X 250,000 = $50,000.
But then, you don’t pay that.
You defer payment of the Capital Gains taxes by purchasing a Replacement Property, and engaging in a Section 1031 Like Kind Exchange.
In other words, you use your “net sales proceeds” from the sale of the property to buy another business or investment asset of equal or greater value. That means you do not have to pay the $50,000 in Capital Gains tax to the IRS.
You keep the $50,000.
And that $50,000 tax liability disappears into the basis of the Replacement Property, and stays there until you sell the Replacement Property. And when you do eventually sell it, you can delay the existing tax liability again by engaging in a second Section 1031 Exchange.
(After you have finished reading this, you need to protect yourself against the bad advice that seems to be rampant on the web by going to the tabs above and reading about Intent, Refinance, and Dealer Property.)
Free Money Plus Leverage
Leverage and time are the two things that will make you rich.
Let’s assume that you walk away from the closing table with $250,000 net sales proceeds, the same as your capital gains. We will ignore expenses for now so that we can deal with round numbers.
(I have a real world transaction that goes step-by-step in my book, “How To Do A Section 1031 Like Kind Exchange” which you can see below, with the other books.)
For purposes of illustration, and so that we can track exactly what happens to the $50,000 that you don’t send to the IRS, let’s assume that you use that $250,000 to buy two separate Replacement Properties with your net sales proceeds instead of just one, which is allowed under Section 1031.
You take $200,000 of your $250,000 profit, get a 75% loan for $600,000 and purchase one property for $800,000. We won’t track this property right now.
You take the remaining $50,000, which is equal to the amount of taxes that you were going to pay to the IRS, use it as your down payment, get a loan for $150,000 and buy another income property for $200,000.
This is money that would not be available to you if you had sent the check to the IRS. At this point it has become “Free Money Times Four.”
Now, let’s look at the results of the $50,000 investment.
Even if you only hold it for ten years, the results are amazing.
Assume that the property will cash flow, and pay all of your expenses, including repairs, property taxes, and principal and interest on the note. This should be your strategy in any investment.
Also assume a conservative 6.0% annual appreciation in value for the property, although the real figure, based on historical data, is actually 6.7% annually.
In ten years, the property will increase in value from $200,000 to $358,170.
- Year 1 – 200,000 X 1.06 = 212,000
- Year 2 – 212,000 X 1.06 = 224,720
- Year 3 – 224,720 X 1.06 = 238,203
- Year 4 – 238,203 X 1.06 = 252,495
- Year 5 – 252,495 X 1.06 = 267,645
- Year 6 – 267,645 X 1.06 = 283,704
- Year 7 – 283,704 X 1.06 = 300,726
- Year 8 – 300,726 X 1.06 = 318,770
- Year 9 – 318,770 X 1.06 = 337,896
- Year 10 – 337,896 X 1.06 = 358,170
This works on the same principle as compound interest. It is the original amount multiplied by 1.06 (106%) to the tenth power (1 x 1.06 x 1.06 x 1.06 x 1.06, etc. for ten times) which is $200,000 multiplied by 1.79084769651. This is an increase of approximately 179%.
(I recommend that you look at my book “50 Real Estate Investing Calculations” which includes the Rule of 72, the calculation that says that you can divide an investment by the annual Return and the answer is how many years it will take for the investment value to double.)
Along with the property value going up to $358,170 over the ten-year period, the balance owed on the $150,000 note went down to $120,000.
This means that your equity in the property has increased to $238,170 (358,170 minus 120,000).
Your original equity of $50,000 (the IRS’s money) has increased about 475%. This is also called your Cash-on-Cash Return.
Cash Out
Now we can take this a step further, and look at what happens if you decide to cash out at this point (without doing a Section 1031 Exchange), and sell for the Fair Market Value (FMV) of $358,170.
You will have four amounts deducted from your sales proceeds before you see the amount that you get to keep.
The first deduction will be the note payoff of $120,000 and that leaves $238,170.
The second will be the capital gains tax on your profit of $158,170 (the difference between the $200,000 purchase price and the $358,170 sales price). Assume a 20% rate and this amount is $31,634.
That will leave $206,536.
The third is tax on the recapture of depreciation of $65,400 taken on the Duplex. This rate is up to 25% and the tax is $16,350.
(This figure assumes all of the depreciation was on the real property itself. Any depreciation taken on appliances, carpet, or other personal property is Section 1245 property, which recaptures as ordinary income and cannot be deferred under Section 1031 — see the Personal Property page.)
(I will explain Depreciation Recapture later. For now, just understand that the amount of depreciation taken is now taxed as Ordinary Income, up to a maximum rate of 25% when you sell the property.)
This leaves $190,186.
The fourth deduction is an example of how the deferred tax concept of Section 1031 Exchange actually works. Pay close attention and take notes here.
Remember that you deferred $50,000 Capital Gains tax on the original $250,000 in profit. And you used one-fifth of that $250,000 profit to re-invest in this property. Now you are selling this property, so one-fifth of the taxes that you deferred on that original sale are now due.
That amount is $10,000.
- Gross Sales Proceeds$358,170
- Note Payoff(120,000)
- Net Sales Proceeds$238,170
- Capital Gains Tax(31,634)
- Depreciation Recapture(16,350)
- Deferred Tax Payment(10,000)
- Cash to Seller – After Tax:$180,186
Consecutive Section 1031 Exchanges
So now you have $180,186 to invest, and you are looking for properties. Using the 25-75 ratio, you should be able to take title to about $720,750 in property.
25% Down Payment equals $180,186. 75% Loan equals $540,560. Total Funds Available (100%) equals about $720,750.
That’s not bad for starting with $50,000 of Free Money. But what if you could increase that $720,750 by a third, to about $950,000 by doing the same thing, but doing it differently?
Instead of cashing out, you do another Section 1031 Like Kind Exchange.
You still do the same sale, but you take your “net sales proceeds” of $238,170 and use it as a down payment and get another 75% loan for $713,510 and purchase a new property in the price range of $950,000.
You now own a $950,000 Apartment Building with about $240,000 in equity, and the Fair Market Value (FMV) of the property, and therefore, your equity, is increasing about $57,000 each year through market appreciation.
And all of this is because of Section 1031.
So, the next time you are talking about a Section 1031 Exchange, and someone says, “Oh, nobody does that, spend your time doing more deals,” just smile and be glad that you learned about Free Money.
Where Do I Go From Here?
Go to the Home Page and read about the Players and Terms, and then you are ready to go to the 1031 Exchange Rules Page and read about the Delayed Exchange, where you can start putting together your own Section 1031 Like Kind Exchange.
But first, you might want to take a look at all of my books below to see if you might benefit from any of them.