We have discussed many of the benefits of a tax-deferred exchange but what can a 1031 exchange really do for you? This Friday Free for All will provide an example of the true power of a 1031 tax-deferred exchange. Let’s look at a specific scenario and how a 1031 exchange can benefit the seller.
The seller is a single individual taxpayer who has owned the property he is selling for over 20 years. Let’s assume the following:
- The seller has an annual salary of $125,000 and $50,000 of additional income including interest, dividends and rental income
- The seller originally paid $250,000 for the property
- The seller has made no capital improvements to the property
- The seller has taken $150,000 of depreciation
- The property is now selling for $500,000
Keeping this in mind, the seller would have the following tax liability:
- Capital gains of $250,000
- With $175,000 of income plus the $250,000 of gain, he falls into the 20% capital gains tax rate
- 8% Net Investment Income Tax on all unearned income, including rental income and capital gains for high earners
- Highest income tax bracket of 37%
- Depreciation recapture of $150,000 at 25%
- Would likely be subject to the Alternative Minimum Tax or AMT
Now let’s look at the numbers.
| Taxable Sale | 1031 Exchange | |
| Sale Price | $500,000 | $500,000 |
| Capital Gains | $37,500* | 0 |
| 3.8% Medicare Tax | $9,500 | 0 |
| Depreciation Recapture | $37,500 | 0 |
| Federal Tax Liability | $84,500 | 0 |
| Net Proceeds | $415,500 | |
| Buying Power (putting 30% down) | $1,385,000 | $1,666,667 |
*Capital gain taxes are calculated at the rate of 15%. The actual taxes would likely be more because a portion of his gain will be taxed at the 20% rate
What does this mean? This means that, with a 1031 exchange, the taxpayer can:
- Immediately defer a $84,500 federal tax liability
- Reinvest all proceeds into a replacement property
- Defer state tax (except for Pennsylvania residents or non-residents selling property in the Commonwealth)
- Leverage the extra $84,500
- Acquire new property worth $281,667 MORE than if he had done a taxable sale
- Collect higher rents from Day 1
- Have more depreciation available
- Enjoy greater appreciation long-term
1031 exchanges are a great tax-deferral strategy. They are also a way to increase your return on investment, use pre-tax dollars to diversify your real estate portfolio and so much more. Find out more about the power of 1031 exchanges by registering for one of 1031 CORP.’s Wealth Building Webinars.
