Case Study: The Compounding Benefits of a 1031 Exchange
The immediate tax deferment from a 1031 exchange leaves the taxpayer with more money to reinvest in the short term. It can also help them hold onto around 25% more from a property sale by avoiding four levels of taxes. On paper, there's no direct profit for the investor - just taxes that are not paid upfront - but having more to reinvest also means greater returns over time.
The most readily apparent benefits of a 1031 exchange occur within the 180-day exchange window: the taxpayer offloads an investment and acquires a new one without losing any of the investment's value to taxes. However, being able to reinvest that money instead of losing it to taxes does even more for the taxpayer in the long term.
Consider the impact of a 1031 exchange on a hypothetical investor looking to change the nature of her investments.
Anne Jones has owned a retail center for approximately two decades, collecting rents and taking $10,256 in annual depreciation deductions. That has reduced her tax basis to $244,880. However, she has now decided she does not want the management responsibility and will sell the retail center for a market value of $1.25 million, enabling her to purchase a more passive investment, like a DST.
If Anne doesn't use a 1031 exchange, she will only have an estimated $942,400 to reinvest after paying all applicable taxes, as follows:
- Federal capital gains tax (20%): $153,000
- Depreciation recapture tax (25%): $51,280
- State capital gains (approximately 5% — varies by state): $38,250
- Net investment income tax (3.8%): $29,070
- Total Tax Liability: $271,600
- Reinvestment Total Without a 1031 exchange: $942,400 ($1,250,000 - $271,600)
Anne can defer her tax liability at all four levels if she starts by engaging a Qualified Intermediary (QI) to help her structure both the sale and reinvestment as a 1031 exchange. If every step of her transaction occurs within a 1031 exchange, she will have the full $1.25 million to buy the new property.
The immediate impact of retaining almost a quarter of the total sale value is that Anne is not forced to buy a less valuable property as her new investment. However, the long-term effect is much more significant. Assuming a 7% compounding rate of return over 10 years, reinvesting the entire $1.25 million will nearly double Anne’s investment to approximately $2.45 million.
If Anne instead sold the retail center without a 1031 exchange in place, she would only have the $942,400 to reinvest. With a 7% compounding rate of return over 10 years, her investment with the reduced sum would be worth approximately $1.85 million. Again, her return on the purchase price is almost double, but she has missed out on roughly $600,000 compared to the returns she would have had with a 1031 exchange. And that is just in the first 10 years.
The benefits of a 1031 exchange in both the long and the short term are clear. Deferring taxes when selling eligible real estate to reinvestment enables better immediate investments and ensures taxpayers do not miss out on compounding returns.