A 1031 Exchange (Tax-Deferred Exchange) is one of the most powerful tax deferral strategies remaining available for taxpayers. Also known as tax-deferred exchanges, 1031 exchanges refer to section 1031 of the U.S. Internal Revenue Code, which allows investors to defer capital gains taxes when they exchange qualified real estate for "like kind" properties, and is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of the like kind properties. Many property owners are starting to realize that exchanging is a powerful tool that can accomplish a variety of investment goals beyond lowering the immediate tax bill. You can even buy and exchange properties so that you reallocate your commercial real estate investment portfolio without paying tax on any gain realized. A particularly intriguing aspect of implementing an exchange strategy is its wealth-building capacity.
A penny doubled every day for a month is worth only two cents on day two, but on day 31 it is worth $64 million. Compounding plus time can indeed produce impressive investment growth.
Potentially the most powerful benefit of a 1031 exchange, the compounding effect also is the most overlooked. The key to getting the highest compounding result is keeping all of the money working for the investor, not only for this tax year, but also into the future. In a 1031 exchange, the amount of tax that otherwise would be paid is reinvested. The projected future value of the compounded yield on the deferred tax becomes very substantial over time.
Many buyers also add financial leverage, by taking the taxable gains on a sale, and using it buy a larger or stronger investment grade property, which significantly amplifies the compounding effect. For example, in 1988, a property owner sold a $1,000,000 property that had a $200,000 basis. Without utilizing an exchange, the gain on the sale would have been $800,000 with approximately $200,000 in taxes due. After paying the taxes, there would have been approximately $800,000 after-tax cash to reinvest.
But if the property owner exchanged the property and bought a $1,000,000 income-producing replacement property that was 85 percent occupied. The property owner put $200,000 down exactly the same amount the property owner otherwise would not have had without the exchange. Two years later, after making necessary management adjustments, the property owner increased the property's occupancy to 94 percent and sold it for $1.4 million. The $200,000 that the property owner put down on the property (money that would have been used to pay the recognized gain in 1988) added to the $400,000 the property owner just made equals $600,000.
The property owner did another exchange and put the $600,000 in proceeds down on a $2 million income property that had been under-managed and was at 83 percent occupancy. Three years later, after achieving 92 percent occupancy in the property, the property owner sold it for $2.6 million. With the $600,000 the property owner had put down plus the $600,000 the property owner made on the sale, after only five years the $200,000 tax that was deferred had grown to $1.2 million. Alternatively, without the exchange strategy the property owner would have had no compounding benefit from their investments because the initial $200,000 would have been paid to cover the tax obligation.
Compounding combined with leverage can build wealth very quickly. Over a 12-year period, this the property owner did five exchanges and turned the money that they otherwise would not have had ($200,000) into $4.8 million.
