The Hidden Benefits of a 1031 Exchange
The 1031 exchange is an extremely powerful tool in your tax arsenal, and I think it’s even a little more powerful than people realize. If you're unfamiliar...
(As a disclaimer...I'm not a CPA! There are all sorts of rules and regulations around this product, so please talk to your CPA or lawyer in order to make sure you understand the details.)
I used this tool for the first time in late 2021 and the results were incredible…I sold my first rental property (my beloved Gastonia Fourplex) and instead of paying significant capital gains tax on the $183k profit, this exchange allowed me to use that equity in order to purchase my Hubbard Duplex for $459k.
But Patrick, why would you put 40% down? I thought you were smarter than that.
Great point, I am smarter than that! Thanks for the reminder.
The way I saw it I had 4 options:
I could suck it up and put 40% down
I could find a bigger asset to purchase, one where my down payment was much closer to my equity from the previous deal
I could find two assets to put the 1031 funds into
I could make the down payment on this property and then keep the remaining cash as operating funds for my business and just incur the tax burden
Which one would you choose?
Which option would you choose?
- #1 - 40% down
- #2 - bigger asset
- #3 - multiple assets
- #4 - pull out cash
I chose number four, put ~$93k down on the duplex, and pulled ~$90k out as taxable "boot".
Why? Why take the tax hit on it?
Remember...the 1031 is a tax DEFERRED exchange, not a tax free exchange. If I can avoid a major tax hit I'd much prefer to keep as much as possible out of the exchange, simply because I believe in the future I'll be making much more than I do now (and taxes will be higher).
The beauty is, thanks to the hidden benefit of the 1031 exchange this didn't increase my tax burden at all.
What benefit is that?
Depreciation.
After the 1031 exchange I'm left with ~$90k of taxable income. By working with my CPA and running a cost segregation study on the duplex, I was able to create around $90k of depreciation that could be recognized in Year 1. That means the purchase of a new asset created a ~$90k write off, which offset the rest of my taxable income from the sale.
I walked away from the deal with an upgraded asset in the duplex, plus an additional $90k in tax free capital that I could reinvest in whatever time or fashion I deemed appropriate without the implications or restrictions of the 1031 exchange.
This is a perfect example of why it’s so important to learn the tax implications of different real estate activities and transactions. Play offense by creating more income, play defense by understanding tax strategy to keep that income, use the income to play more offense, and keep the cycle going forever.
Have you done a 1031 exchange? How do you play defense and manage your tax burden? Let other readers hear from you in the comments below!