A 1031 exchange allows an owner of investment property to sell and defer State and Federal capital gains taxes, a 25% tax on recaptured depreciation and a 3.8% Medicare tax (for highest earners). The sum of these taxes can add up to 30% to 40% or higher of a seller’s net proceeds.
Rather than pay these taxes an investor can re-invest the proceeds [45 days to identify and 180 days to close on a property (or properties) of equal or greater value]. This investment strategy has been used by savvy investors as a wealth building tool for over 100 years.
The theory behind it is that when an investment property reaches a high enough equity to value ratio, the property is sold and exchanged for a new property that provides greater cash-flow, tax benefits, diversification and future appreciation.
“Swap ’till you drop” is a term often used to describe this strategy in which a real estate investor continues to buy and exchange investment real estate until they pass. The properties then receive a “step-up” in tax basis and the heirs inherit them unencumbered by any capital gains and recaptured depreciation taxes.
Potential Cash-Flow Benefits
In order to calculate the potential cash-flow benefits of a 1031, it is important for an investor to first determine what their current return is. Many get it wrong when it comes to this calculation. Some think it’s their net cash flow divided by what they paid or put down for the property, but this is not the case. An investor’s true return must take into consideration the current equity (based on the estimated value) in the building and it’s potential for generating a return. Many long-term owners are surprised to discover just how low their true return actually is. Especially when considering the value of their time as an expense and budgeting for unforeseen repairs and increasing expenses.
For investors with smaller equity amounts it can be very difficult to find decent cash-flowing real estate. Cap rates have become so compressed in this category there is very little, if any, return left for the investor. The investor must bet on future appreciation to make up for the lack of cash-flow. With fractional ownership an investor with $100,000 may be able to receive the same monthly return from a similar quality asset as the traditional sole-ownership investor with $1,000,000 or more.
DST properties produce year-1 returns in the 3.5-7% range. They require zero management on behalf of the investor. Reserves are set aside for ongoing repairs and improvements when the properties are initially purchased. Each month additional reserves are contributed to the reserve accounts from the cash-flow, as available. Any reserves remaining upon the sale of the project will be distributed to each owner based upon his or her respective pro rata interest.
If you are a long-term owner of highly appreciated investment property it is important to also consider the tax benefits of doing a 1031 exchange. Not only can you defer all of the capital gains and recaptured depreciation owed, a 1031 exchange is a way to move equity out of an investment that provides little or no tax shelter and into a property with not only potentially higher returns but greater depreciation (tax shelter).
With many DST properties, 60% to as high as 100% of an investor’s return can be sheltered through depreciation.
Potential Appreciation Benefits
A 1031 exchange allows an investor to sell an asset in a flat, declining, and/or over-valued market and re-invest their total proceeds in under-appreciated markets that may potentially see stronger future growth (market appreciation). This strategy can add significantly to an investor’s overall return, if successful. Additionally, by using leverage and incorporating a solid value-add business plan (forced appreciation), an investor may achieves an even higher rate of total appreciation during the holding period.
1031 Risk Disclosure:
- There is no guarantee that any strategy will be successful or achieve investment objectives;
- Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
- Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- Potential for foreclosure – All financed real estate investments have potential for foreclosure;
- Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits