Selling an asset for significantly more than you paid to acquire it always brings gratification. You’ve made a good investment and earned the reward. I’m sure you have plenty of ideas for how you’d like to use it: save it, get out of debt, pay for that item that has so far been out of your financial reach, reinvest it, etc. Oh so many options…
You might not want to get too carried away too quickly. Much of that income will soon be used to pay the taxes you’ve incurred on the appreciation of your asset. You can still save it, spend it or reinvest it; but expect to save, spend or reinvest only a portion of the total amount earned from your sale. This is the inevitable case with most investments. However, if you are in a position to complete a 1031 exchange, it doesn’t have to be your inevitability.
By completing a 1031 exchange, you can defer capital gains taxes incurred on the sale of a relinquished property and reinvest the entire sale amount into a replacement property. Deferring the payment of taxes allows you to keep those funds on your balance sheet, working to continue building your wealth. Likewise, deferring the payment of taxes means you have a larger reinvestment amount that will yield higher returns than reinvesting what would be leftover after paying capital gains taxes.
Here's what you should notice:
• The sale price is the same in both examples.
• The potential annual cash flow is significantly higher in the exchange example.
• The investor in the sale example would have to reinvest in a like-kind property paying a 8.92% annual yield in order to earn an equivalent $22,750 annual cash flow on the reinvestment of the $255,000 sale proceeds.
• The investor in the sale example is only receiving the equivalent of a 5.49% annual yield on their highest potential reinvestment amount had they deferred taxes like the investor in the exchange example.
• Whether you look at the potential income of the investor in the sale example or the equivalent percentage of annual returns this investor will make in comparison to the investor in the exchange example, it is clear that the investor in the exchange example has the advantage to build wealth more efficiently.
• Furthermore, with nearly $100,000 more to acquire real estate, the investor in the exchange example has a greater opportunity to purchase a higher quality property that may yield higher returns than what the investor in the sale example could afford. The investor in the sale example does have the option to acquire a loan to purchase the same property as the investor in the exchange example, but much of the annual cash flow would be used to pay the loan fees, reducing the net cash flow to the investor. Why borrow cash when you can defer taxes and use your own cash to fund your investment?
• Finally, consider how the potential annual cash flow can increase each time the investor in the exchange example exchanges property through a 1031 exchange. With each exchange, this investor defers the payment of taxes on their capital gains and increases the proceeds they have available for reinvestment. For example, after the next exchange, the investor may have $350,000 of available proceeds for reinvesting. Then some years later, after another exchange, the investor may have $375,000 of available proceeds for reinvesting. If the investor continues to invest in 1031 exchange qualified Funds or like-kind properties paying 7% annual returns, the annual cash flow increases with each increase in the reinvested amounts.
1031 exchange investors have the potential to build greater wealth because they take advantage of tax-deferral opportunities and leverage their own income to achieve higher returns on their reinvestments. Give us a call; we would love to help you discover your reinvestment potential. (844) 533-1031
While the information provided above has been researched and is thought to be reasonable and accurate, it’s important to talk with your tax professional regarding your personal tax situation.