1031 Exchange >> Sale v. Exchange Example
Introduction | The Basics | Five Reason to Exchange | Contract Language | Sale v. Exchange Example | Order Form
The benefits of IRC Section 1031 exchanges can be tremendous! Investors are often able to defer thousands of dollars in capital gain taxes, both at federal and state levels. If the requirements of a valid ~1031 exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it. This essentiaily results in a long-term, interest-free loan from the IRS.
AN EXAMPLE
An investment property owner sells a rental property for $400,000. The owner originally purchased the property for $200,000. There is $200,000 of debt and the property has been fully depreciated. The capital gain is approximately $350,000 (assuming 75% of the property is depreciable). If the investor does not do an exchange, federal capital gain taxes would be:
$150,000 (depreciation recapture) x 25% = $37,500
$200,000 (capital gain balance) x 15% = $30,000
$350,000 Capital Gain Taxes Owed = $67,500
The state taxes owed (where applicable) would need to be added to the federal taxes due. Assuming the property owner sold in Illinois, the following additional taxes would need to be paid:
State level (IL) 3.0%, $350,000 x 3.0% = $10,500
Total Capital Gain Taxes (Fed. & State) = $78,000
The next comparison analyzes the value of the new property that could be acquired in a sale versus an exchange. The comparison assumes an investor makes a 25% down payment and finances 75% of the property (75% loan-to-value ratio).
SALE VS. AN EXCHANGE
| | SALE | EXCHANGE |
| Equity | $200, 000 | $200, 000 |
| Capital Gain Tax | $78,000 | $0 |
| Cash to Reinvest | $122,000 | $200,000 |
ASSUMING A 75% LOAN-TO-VALUE
New Property $488,000 $800,000
This example illustrates that the real power of a tax deferred exchange is not just the tax savings. it is the increase in purchasing power generated by this tax savings!
ADVANTAGES OF AN EXCHANGE
1. Preservation of equity
2. Maximize return on investment
3. Increased cash flow from larger properties
Compare the tax savings and additional purchasing power of an exchange vs. a taxable sale:
1. Calculate Net Adjusted Basis
| Original Purchase Price | _____________________ |
| + Improvements | _____________________ |
| - Depreciation | _____________________ |
| = NET ADJUSTED BASIS | _____________________ |
2. Calculate Capital Gain
| Sales Price | _____________________ |
| - Net Adjusted Basis | _____________________ |
| - Cost of Sale | _____________________ |
| = CAPITAL CAIN | _____________________ |
3. Calculate Capital Gain Tax DUE
| Recaptured Depreciation (25%) | _____________________ |
| + Federal Capital Gain (15%) | _____________________ |
| + State Tax (when applicable) | _____________________ |
| = TOTALTAX DUE | _____________________ |
4. Analyze Purchase without an Exchange
| Sales Price | _____________________ |
| Cost of Sale | _____________________ |
| Loan Balances | _____________________ |
| = GROSS EQUITY | _____________________ |
| Capital Gain Taxes Due | _____________________ |
| = NET EQUITY | _____________________ |
| Net Equity X 4 = | _____________________ |
5. Analyze Purchase with an Exchange
| Capital Gain Taxes Due | _____________________ |
| Gross Equity = Net Equity | _____________________ |
| Gross Equity x 4 = | _____________________ |
The real power of a tax deferred exchange is not just the tax savings. It is the tremendous increase in purchasing power generated by the tax savings. With the advantages of leverage, every dollar saved in taxes allows a real estate investor to purchase two to three times more real estate.
Many investors are surprised to discover that capital gain [axes are far higher than 15%. State taxes, which can be as high as 11% in some states, are added to the federal capital gain taxes owed. In addition, depreciation deducted over the ownership period is taxed at a rate of 25%. The net result is often a large percentage of your profits going directly to pay taxes, Under the 4th calculation, the net equity times four (assuming a 25% down payment) is the value of property you could purchase after paying all capital gain taxes.
Under the 5th calculation, involving an exchange, no taxes are paid, leaving the full purchasing power of the entire gross equity to acquire considerably more real estate. In just one transaction, the Exchanger acquires far more investment property than a seller!
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Note: Certified Title Co, LLC cannot give tax and or legal advice. Every taxpayer should review their specific transaction
and potential tax consequences with their own tax and/or legal advisors.
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