In conclusion, of our frequently asked questions we hope have to satisfied some of your curiosity. From investors looking to begin investing in real estate to experienced real estate investors looking for an alternate investment vehicle, investors may be uncertain about how Delaware Statutory Trusts (DSTs) can be used with their 1031 Exchange. Please let us know if you need further clarification or have a question we did not cover in this series. It is our pleasure to discuss the possibilities of DSTs and help investors discover ways to meet their investment objectives.
Question 3: It seems to be a good time to sell my single family rental property and capitalize on the value growth. I am interested in a small office park with significant earning potential, and I think I’d like to reinvest my the sale proceeds. Does exchanging benefit my investment?
Answer: Every investment situation is different, but, in most cases, exchanging will benefit the investment. In this example; the investor receiving capital gains on the first investment, an exchange will benefit the next investment by allowing the investor to defer the capital gains tax payments and have a larger amount of cash to reinvest into the replacement property.
For example, if the rental property was purchased for $300,000 and sold for $500,000, the investor earned $200,000 in capital gains. At the maximum capital gains tax rate of 28%, this investor could owe $56,000 in taxes. Paying an additional $35,000 in closing costs, this investor would have $409,000 to reinvest into a new property. In contrast, if the investor deferred the capital gains tax payment by completing a 1031 exchange, the investor could reinvest $465,000 into a new property. If the new property earned a 7% annual return, the investor who did not complete an exchange would earn $28,630 annually on the new property. However, if the investor had completed an exchange, the same 7% annual return would yield $32,550.
Alternatively, let’s consider the investor who already has a specific property in mind, such as a $1 million business park. Without an exchange, the investor would have to obtain a loan of $591,000. With a 5% interest-only loan, the investor will pay $29,550 from the property’s income to the mortgage lender. With an exchange, the investor would have a smaller mortgage of $535,000 and only pay $26,750 in annual interest payments.
Having more cash to invest because you did not pay capital gains taxes to the IRS means that you can reinvest your funds in a higher valued property and earn a higher annual income or take out a smaller loan and keep more of the annual income.
In the same way, exchanging will benefit the investor whose depreciation deductions exceeded the actual depreciation of the property. If the investor can defer paying the depreciation recapture to the IRS, the investor can increase the amount of cash available for reinvestment.
Furthermore, when you continue the exchange cycle, you can receive a benefit even in the event of a loss on your investment. Consider that you have $200,000 of capital gains that have accumulated from one investment to the next as you have exchanged one property after another. If you experience a $50,000 loss on a subsequent investment, your accumulated capital gains will be reduced to $150,000. If you ever discontinue the exchange cycle, you would only owe taxes on the final accumulated total.
Bottom line: 1031 exchanging allows you to keep and use the money you’ve earned to help you accumulate additional earnings at a faster pace.