Let’s take a look at two different investors who bought and sold properties over a 25-year span.
The investors in both scenarios start with the same amount of money ($50,000), buy the same property (a $250,000 deal, 2nd column below), have the same growth (5% equity growth each year, reflected in the 3rd column below), and reinvest their profit (4th column below) plus their previous down payments as a 30% down payment on their next deal (5th column), but each ends up with a very different amount because of the taxes.
(For simplicity, I do not include closing costs, depreciation, loan paydown, cash flow, or other obvious sources of income and expenses in this diagram. This is simply to illustrate a point.) See below.
Investor #1 purchased a $250,000 property with his $50,000 down payment. After five years, he sold it for $319,070.39. He was able to use the entire profit and his equity he’d built thus far, to put a 30% down payment on his next deal. This continued for 25 years with no tax due, because he continually used the 1031 exchange. Now let’s take a look at the numbers for Investor #2, who chose not to use the 1031 exchange. See below.
After 25 years, Investor #2 ended up with just less than $2.5 million. Although this is still a respectable sum of money, notice that this investor trails Investor #1 by more than $1,000,000! This is because Investor #1 was able to put the government’s money to work by using a 1031 exchange, helping him build greater wealth.
Now, what happens to Investor #1 at the end of year 25? After all, the 1031 exchange is simply a method of tax deferral, not tax avoidance. Or is it? Let’s talk about that next.
The 1031 Exchange End Game
In our examples, Investor #1 ended year 25 with $3.8 million, while Investor #2 ended with $2.4 million. But what happens after that? Typically, there are two common scenarios for any real estate investor when they are done with their investment career.
1. Cash Out
Some investors decide to exit the real estate game entirely, cashing in their chips and walking out the door. In other words, they decide that they will pay the IRS what they owe after selling all their properties. However, at this point, they are not simply paying the taxes on that final property’s profit but (put very simplistically) on all the properties for which they have ever used the 1031 exchange. Because the “cost basis” of a property is carried forward on every deal, that final tax bill will likely be exceptionally large.
Keep in mind that if you opt for this end game strategy—cashing in your investments and paying the tax—you will still likely have significantly more income than if you had paid taxes each time you sold a property.
2. Die and Pass It All On
That’s right, many investors simply choose to hold their properties until the day they die, and to pass the properties on to their heirs. The benefit of this approach is that current inheritance laws allow the heirs to receive the property on a “stepped up basis,” which means the tax consequences virtually disappear.
For example, let’s say the adjusted basis on a property, after numerous 1031 exchanges and lots of time, is $200,000, and the property is worth $3,000,000. If the owner sold the property five minutes before dying, they would owe taxes on the $2.8 million in gain. But if the estate passes to the investor’s heirs, the basis is automatically bumped up to the fair market value, or $3,000,000. The heirs could then sell the property and pay little, if any, tax. Of course, there are special rules and fine print that accompany this (especially for the exceptionally wealthy), so be sure to talk with a qualified professional about your estate planning!
Understandably, not every investor wants to hold on to properties until they die. I know I don’t want to be dealing with tenants when I’m 40 years old, so being a 100-year-old landlord is absurd! So how does one get around this?
You do it by trading up into properties that are significantly easier to manage! For example, perhaps you could 1031 exchange your equity into a multimillion-dollar shopping mall, as part of a syndication with hundreds of other investors. Or trade it into a NNN lease commercial investment where the tenant pays everything and you sit back and collect a check.
There are hundreds of ways to make money with real estate, so simply trading up to a more passive method sounds pretty good to me.