This one was a lot of fun. I like to dork out on the numbers.
I get asked all the time: "Should I do a 1031 exchange?"
Again the answer: Depends.
Depends on what you bought the property for and what you are selling for and how long you have owned it. Depends on your overall financial situation and what your needs and investment goals are.
Typically, if you have not owned a property that long, say 2-4 years, it makes sense to pay the tax and reset you cost/tax basis. That is unless your gain is huge, then you probably want to do a 1031.
OR if you have owned a property a long time or inherited it and the basis is very low or zero then you should do a 1031. This is situation that 90% of my clients fall into.
Below are some quick and dirty numbers from the episode "NNN 1031 Secret #2" of the 1031 Exchange Passive Income and Investment Series on iTunes and every other podcast platform and YouTube. The audio has more info and details than this post and I dive into this topic in depth so make sure to download it for your next drive, walk or exercise or for when you are doing the dishes.
A lot of times people who are new to a 1031 exchange get cold feet, have misgivings or get overwhelmed with the process and say "I'm just going to pay the tax."
I say "It's your money. You should definitely do what you want and need to. But consider this...."
Basically, in my humble opinion, the 1031 exchange is the greatest wealth building tool known to mankind besides compound interest.
For the purposes of this example I am going to use $1,000,000 as the total sale proceeds. If you have $5MM or $10MM sale proceeds, the cash flow and capital accumulation are of course magnified 5X or 10X.
Listen to the show for details but most people considering a 1031 have zero or very low tax basis in the property they are selling. The majority of my clients have pretty much the entire sale price as the capital gain. On a $1MM sale, with zero basis the capital gain is $1MM. I have one client right now with a $15MM gain and have worked on one with a $40MM gain. How does paying $10MM to $12MM in tax sound? Ouch!
Fed capital gains tax is 23.8% right now with the ACA tax included and most states also have a capital gains tax. The IRS will also tax you on the depreciation you took over the life of the investment which is called a recapture tax and that is 25%. In effect, the capital gains tax is much higher than the stated rate dependent on how much income you sheltered with depreciation over the life of the investment. A good rule of thumb is 30% of the gain goes to Uncle Sam.
In the examples below, if you have a $1MM gain/sale, $300k goes to taxes and you have $700k left over. Yes a 30% reduction in investment capital.
BUT I look at inversely, if you do a 1031, the government allows you to keep and use (for the time being through deferral) the $300k. This is about 43% more investment capital (30% tax of $1M is 300k but 300k more than 700k is 43% MORE.)
This is the kicker. If you can invest $700k or invest $1MM and you get the benefits of the investment such as cashflow, depreciation and appreciation, which would you choose?
Most of us would rather get the benefit of the $300k now and in the future rather than cut a check to the IRS now. Once you write the check, $300k of your money is gone. POOF!
This is what the numbers look like. I ran them two ways. One based on a triple net investment for cash flow. And two for an IRR deal like development or value add or sell in the future type deal.
Effects of 1031 on Cashflow
For a NNN investment, let's say you get 6.5% cap rate or annual cash flow. This is all unleveraged of course.
At end of the day you have 43% more money invested and therefor 43% more benefit.
Pay tax now of $300k or get $20k more per year in cash flow on the $300k. Over 5 years this is $100k more. Over 10 years this is $200k more.
Would you rather have $65,000 per year or $45,500 per year?
Or another way to see it:
Lose $300k now (send a check to IRS) and lose $20,000 per year of additional income for the rest of your life!
Effects of 1031 on Capital Growth
The other way I looked at was from an IRR perspective or overall rate of return. (IRR is Internal Rate of Return or annual overall yield) Let's say you have an opportunity to invest in a NNN development or apartment building with upside or a value-add investment deal. The IRR takes into account all cashflows including purchase and sale and costs etc.
15% is a reasonable IRR. You can get that on strip centers and apartment buildings and rehab projects. Most developers are targeting 20-30% IRR's so 15% is reasonable.
Hmmmmm.... 1031 or no?
Over 5 years grow your $1MM to over $2M? Or pay the tax and leave $603k on the table?
Over 10 years grow your $1MM to over $4MM? Or pay the tax and leave $1,213,667 on the table?
Easy decision for most of us.
Pay the Tax and Invest Outside of the 1031?
Earlier this year a client was wavering and going back and forth on a 1031 exchange. They had $3.6MM from the exchange. They thought they could pay the tax in order to get higher yields outside the 1031.
Sure there are more investments outside of the 1031 like stocks and private equity etc.. However, when compared to NNN 1031 Investments those investments are going to be much more risky. This client's goal was secure, passive income and capital preservation. Paying the tax and trying to invest in these other types of investments were totally contrary to these goals.
Let's say they could get 6.5% cap rate/yield on the NNN 1031. That is $234k per year of income.
They were looking at over $1M of taxes. Poof!
At the end of the day, after paying tax and reinvesting they would have to get a 9.3% cap rate or IRR to get what they would get on the 1031 NNN property.
Not sure about you, but I don't know of too many investments, if any, paying 10% per year that are hands off, safe and protect your capital. Maybe Madoff can help?
Here are the numbers:
Another option here which many of my clients have is to do the 1031 all cash then refi. The IRS does not tax the refi proceeds. In this case the client could have easily gotten a 50% loan and pulled out $1.8MM. Then the tenant pays back the $1.8MM loan and the $1.8M in proceeds could be invested in something at a higher yield.
To me, this is the ultimate benefit. On the $1MM example, a person completes a $1MM 1031 at 6.5% then pulls out $600k (60%) tax free and reinvests in whatever they want. This is 900k of money that will accrue to your benefit. ($300k tax deferral and $600k loan reinvested).
Now, that is wealth building!
What do you think Warren? (Buffet of course)
Let me know your thoughts and if you think a 1031 exchange is right for you!
Text me at 970-618-4086 or get a free 1031 exchange and real estate investment consultation here.
Cheers, Thomas