The Power of Tax Deferral
preserving Wealth Through Strategic Tax Deferral
As Robert Kiyosaki once wrote, ‘It’s not how much money you make, but how much money you keep.’ Maximizing investment equity is crucial for long-term wealth building, and tax deferral plays a key role. Tools like the 1031 exchange allow investors to defer capital gains taxes on property sales, enabling them to reinvest the full proceeds into new opportunities.
By continually deferring taxes through 1031 exchanges and holding real estate over the long term, there’s even the potential to eliminate deferred taxes altogether. In short, the strategy is simple: defer, defer, defer… and ultimately, eliminate. The example below highlights the return advantages of utilizing this strategy.
#1 Equity to Invest
A 1031 exchange, also known as a like-kind exchange, is an effective tax-deferral strategy that allows real estate investors to postpone paying capital gains taxes. By selling one investment property and reinvesting the proceeds into another of equal or greater value, investors can utilize this strategy under Section 1031 of the Internal Revenue Code to defer capital gains and depreciation recapture taxes on qualified properties.
In the example provided, we estimate the tax on cash rate at 35%, which would reduce the equity available for your next investment by $350,000 if you don’t utilize a 1031 exchange. To better understand your particular tax position and how a 1031 exchange could benefit you, consider booking a no-cost consultation with us. We can provide you with an estimate and help guide you through the process to ensure you’re making the most informed decision.
#2 Year-One Exchange Advantages
In the first year after utilizing a 1031 exchange, investors immediately benefit from deferring $350,000 in taxes. Remember, building wealth is about how much you keep. This deferred amount means that the “No 1031” investment must generate a return 54% greater than the 1031 investment just to keep pace. Moreover, this higher performance isn’t a one-time requirement—the “No 1031” investment must continue to outperform by this margin every year, highlighting the significant and ongoing financial advantages of a 1031 exchange.
#3 The 1031 is a Potential tool for Increasing Net Worth
By leveraging a 1031 exchange, investors can continuously defer taxes, allowing the reinvested capital to benefit from compounded returns over time. As the chart illustrates, assuming the same 7.0% annual return, the advantages of deferring taxes and reinvesting the full proceeds are significantly magnified over the long term.
The compounding effect means that the difference in value between a 1031 exchange and a non-1031 investment grows exponentially, with the gap widening dramatically over 10, 30, and 50 years. Even when adjusting for inflation, the benefits continue to grow, underscoring the power of this strategy. This approach serves as a powerful tool for increasing net worth, as the reinvested untaxed gains have the potential to generate substantially greater returns, further enhancing overall wealth over the long run.
#4 1031 Exchange RE Advantages by Year 10
Looking specifically at real estate investments, the magnified difference becomes evident over just a 10-year hold, assuming 4.0% cash flows and 3.0% appreciation. The ability to defer capital gains taxes through a 1031 exchange allows investors to reinvest the full proceeds from a sale, leading to significantly greater real estate value over time compared to paying taxes on each transaction. The chart above clearly illustrates how these advantages compound, resulting in a notably higher fair market value and total return by year 10. Making up this up-front tax difference would be incredibly difficult, requiring investments in assets with likely more risk to achieve similar returns. It would be even tougher to bridge this gap if the investment were only held for 5 years, as many real estate and DST investments are.
#5 Defer Taxes Forever!
And here’s the real kicker—under current IRS rules, you can effectively eliminate this deferred tax through a basis step-up at death. In community property states like California, this step-up in basis occurs when the first spouse passes. The compounding power of tax deferral, as shown in the previous steps, allows your wealth to grow significantly over time.
Many in the real estate investment community continue to exchange properties through 1031 exchanges throughout their lives, a strategy often colloquially referred to as “swap ’til you drop.” While the phrase may be a bit crude, the strategy is powerful: by continually deferring taxes, your heirs, including your spouse, can inherit the enhanced, compounded wealth with substantial tax savings. This wealth can then be distributed among them, donated to charity, or distributed in any way you choose.
