1031 Exchange 101

The 1031 Exchange is one of the better things about investing in apartment buildings.

It’s a section of the tax code which allows investors in investment property to defer capital gains taxes on property sold in exchange for re-investing the proceeds in more property.

To understand why it’s such a powerful tax loophole, we need to look at an example of someone who sells without using a 1031 Exchange:

  • Joe Schmoe bought his building for $1MM fifteen years ago all cash (no mortgage)
  • It’s gone up in value 50% and he sells it for $1.5MM (assume no transaction costs)
  • Joe gets back his initial investment of $1MM
  • Plus, Joe has a capital gain of 50% or $500,000
  • The federal government taxes Joe at 15% of $500,000 or $75,000
  • California taxes him at 9% of $500,000, or $45,000
  • So, in total, Joe needs to pay the government $120,000 of his $500,000, leaving him with $380,000 in profit
  • He now has his original $1MM plus the remaining $380,000 to invest
  • Let’s say he uses a 75% LTV mortgage of $4,140,000 to buy the new building
  • He can buy a building for $5,520,000, using his $1,380,000 as a downpayment and borrowing the rest

Now let’s compare Joe to Mary Moneybags who uses a 1031 Exchange to sell her property:

  • Mary also bought her building for $1MM 5 years ago all cash
  • Her building also went up in value 50%
  • She sells using a 1031 Exchange, so she pay no capital gains tax at this time
  • She gets to use the full $1,500,000 she receive from the sale to buy a new building
  • She also uses a 75% LTV mortgage
  • But she can buy a $6,000,000 building using her $1,500,000 downpayment

Now run the experiment ahead ten more years, with property values increasing another 15%.

Joe’s building, which he bought for $5,520,000, is now worth $6,348,000. Mary’s, which she bought for $6,000,000, is now worth $6,900,000. Assuming there has been no change in the loan balances (these were interest only loans), Joe’s equity is $6,348,000 value -$4,140,000 loan balance = $2,208,000. And Mary’s equity is worth $6,900,000 value – $4,500,000 loan balance = $2,400,000.

Without being any better of an investor or manager than Joe, Mary is magically worth nearly $200,000 more than Joe is, simply because she avoided taxation on the original sale of her building. And that is the magic of the 1031 Exchange.

N.B. I’m not an accountant or lawyer and this isn’t tax advice.