In fact, we regularly see 1031 like-kind exchanges that really only enrich the brokers and not the investors.
In this blog post, therefore, I want to talk about how sec. 1031 exchanges work—and when they really don’t work.
Sec. 1031 Like-kind Exchanges in a Nutshell
Let’s start our discussion by explaining how Sec. 1031 exchanges work and how they delay the income taxes you’ll pay.
Suppose you have a property you’ve purchased for $1,000,000. If the property appreciates to $2,000,000 and you sell, you’ll pay income taxes on the $1,000,000 of appreciation.
In many states, when you combine the federal long-term capital gains tax with state income taxes and then, possibly, with the net investment income tax, you may be paying a tax equal to 20% to 25%.
With a $1,000,000 of real estate profit, then, you may be looking at $200,000 to $250,000 in taxes. Ouch.
However, if you do the transaction correctly, you can trade your $2,000,000 property (the one you paid $1,000,000 for) for some new property—and not pay any taxes at the time of the trade. (By the way, you report a like-kind exchange on a form 8824 and that form’s instructions actually give you a pretty good overview of how the mechanics work, in case you’re interested.)
You might, for example, be able trade tax-free your $2,000,000 property for a $3,000,000 property if you’re willing to bump your mortgage up by $1,000,000.
That sounds good. But two friction points appear with this gambit.
Sec. 1031 Like-kind Exchange Tax Deferral Benefit
The first thing to recognize is that you haven’t escaped that tax on your real estate profits. You’ve only delayed paying the tax. At some point, with an example set of numbers like those provided earlier, you probably will pay that $200,000 to $250,000 of tax if you sell the property.
The real estate profit you’ve deferred paying taxes on just gets added to the real estate profit you’ll have to later pay taxes on.
Note: To be fair, I should point out that one group of real estate investors may not need to worry about later paying taxes deferred with a Sec. 1031 exchange strategy: Investors who will never sell their properties.
Sec. 1031 Like-Kind Exchange Transaction Costs
The second thing you need to recognize, if you’re thinking about a like-kind exchange, is that you pay transaction costs to sell your first property even though you’re doing the Sec. 1031 transaction.
Again using the example of the property you bought for $1,000,000 but which is now worth $2,000,000, if you sell the $2,000,000 property you may pay a 6%-ish transaction cost once you include a sales commission and the other fees.
A 6% transaction cost on a $2,000,000 sale equals $120,000.
You want to compare that $120,000 cost to the $200,000 or $250,000 in taxes you get to delay paying.
Many times, the economics simply don’t support this financial math.
In the example here—where you’ve enjoyed 100% appreciation of your first property—that 6% transaction cost equals about a 12% tax. Ouch. That’s too much, right?
Three Other Things to Keep in Mind
Let me wrap this blog up by throwing out three final quick points about using Sec. 1031 like-kind exchanges in your real estate investing.
First, the less appreciation you’re trying to delay paying taxes on by using a like-kind exchange, the higher the implicit “real estate broker” tax you pay. For example, suppose you purchase a $1,000,000 building, see the building’s value grow to $1,500,000, and then pay a 6% commission to do a 1031 exchange. In this case, you pay an 18% “real estate brokers” tax to delay paying a 20% or 25% income tax. That seems pretty bad.
Second, the smaller the selling costs and the bigger the appreciation as percentages, the less significant the effect described here. For example, if an investor had purchased a $1,000,000 property which had appreciated to $3,000,000 and the investor could cut the selling costs from 6% to 3%, then the $90,000 of selling costs works out to a 4.5% “real estate broker’s” tax on the sale of the first building. That’s a way better deal.
Third, finally, I’m using bigger numbers here than many real estate investors will encounter, but the same basic logic applies if you’re talking about a property that you initially purchase for $100,000. Don’t assume, therefore, that what we’re talking about here doesn’t apply to a “smaller potatoes” situation.
Other Real Estate Posts You Might Enjoy
Treating Real Estate Profits as Capital Gains (an article at our CPA firm website)