October 15th, 2008 by Michael Oliver

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Few if any investments offer as many tax deductions, and tax advantages as real estate. The largest of all these and the one that not many people know much about is the 1031 exchange. A 1031 exchange allows a real estate investor to sell an investment property (at a gain) then buy another property completely tax free. Most people get hung up and say “Well if I sell my investment property and then re-buy I’m not really gaining anything.” That is true until you take into account the magical properties of compounding I will give you a 15 year example. Let’s say you purchased a 100k small investment home 15 years ago and after 5 years the property was worth 135k. (That amounts to a normal rate of return.)You then sell for 135k after fees ect lets say 7%= $125,500 plus over 5 years you would have paid down your mortgage a little bit. Also we will assume you didn’t put any money down which is not really possible but this is a blog post not a University Thesis. Ok so at this point I’ll sum it up:

-Bought an investment property for 100k

-Sold it for 135k netting you the investor roughly $25,500 (after fee’s/ costs of sale)

-Over the 5 years of paying the mortgage that was paid down $7500. Again remember as long as your getting a positive cash flow SOMEONE else is paying down that debt for you so that’s additional gains…

-On paper you’re up $33,000 in your first 5 years. Not bad at all but lets say you don’t need the money and you also don’t want to pay the roughly 33% capital gains tax which would rake 10k off the top, What can you do?

This sounds like the perfect case for a 1031 exchange, under this IRS tax loophole you will be able to buy a new property re-invest the monies made and pay no taxes. Now these HAVE to be set up properly meaning once your property sells the money must sit in the escrow account. This money cannot be touched by you. Even prior to selling you must claim this will be a 1031 exchange. After that you have exactly 90 days to “identify” (tell the government which new property you would like to purchase with the tax free money.) then you have another 90 days or 180 total to close that deal. (or any other in case that original property purchase falls apart.) If you don’t have a new property in your name by day 181 (counting all holidays; everything) then you will need to be sending in this case your 10k to the government. Ok let’s go back to the example and see what now happens:

-You complete your 1031 Exchange by purchasing a $333,000 4-plex in a high rent, high demand area. (Think University Of Arizona area.) You put your 33k as down payment allowing you to get a decent mortgage rate.

-Since it’s a 4-plex and you put money down, you’re renting out each unit on average for $700/mo. Your mortgage is $2100/mo netting you the investor a gross income of $700/mo. PLUS, since it’s a 4-plex “if” one of the units is vacant your still breaking even vs. a single property when there is a vacancy your on the line 100% until a new tenant is found. This is a much safer way to go limiting your risk.

-Ok you had the property 5 years and you decide. “The market had done well every year the rents went up, little maintance was needed I want to move up the real estate investor ladder.

-You decide to sell: now since you made the choice to purchase a $333,000 property vs. holding the $135k property you had originally started with the “Compounding Factor” is going to reward you very nicely.

Even at 5% rate of return (which as we see in the current market is not in any way a guarantee, but historically below average rate of return for real estate in the US.) the $333,000 property is now worth roughly $425,000. WOW! PLUS you received lets call it $500 a month in positive cash flow. (I am accounting for vacancies, repairs, and also considering the raised rental rate every year.) That throws on an additional $30,000 in profits! Now these are real world examples that can easily be achieved.

-So at this point that property alone made you as the proprietor: $122,000 in 5 years!

(Recap)
Bought for 333k sold for 425k=92k
Free cash flow of $500/mo for 60 months=30k
Total: $122k

Ok so lets take out the fees for selling which again on average equal 7% that accounts for real estate agent fees, escrow fees, the 1031 additional fees to have it set up right, etc. 425,000-7%= $395,250

-But hang on someone or in this case 4 people at a time were paying down your mortgage so your 300k loan amount (remember you put down the 33k you made on the first property) your loan amount or (payoff) is $280,000….Putting an additional 20k in your pocket. So after all is said and done.

You now have $145,250 (assuming you didn’t spend the 30k in monthly profits from the cash flow, but even if you did it’s YOUR money anyway.) So in 10 years you have amassed $115,250 in capital gains that you can now do the same thing with. But instead of buying a $333k property maybe you buy a $550,000 small apartment and in that case your $115k would be a little more then 20% down which should get you a nice monthly rent roll netting you a reasonable amount of cash flow. Or you could go further and maybe purchase a $750,000 small apartment complex and your 115k is still a 15% down payment. Now if you did buy the 750k property and got 5% return the money would be DOUBLE what it was on your last deal. When all was said and done there not even counting cash flow you would have amassed $230k in profits from that property plus the cumulative $115k you put down which would equal $345,000 in cash to you if you so choose to sell and cash out! All in 15 years! Again I’m not even counting the monthly cash flow OR the fact that other people are paying down your mortgage and allowing you to owe less every month. At that point (cash out) you would be responsible for the capital gains tax on the entire $345,000.However with 15 years of compounding on money that had there been no loophole would of not of been able to be re-rolled into new property, you would have MUCH less then the $345k you now have.

So in summary this is how people get rich in real estate they buy good properties, manage them well, and take all the tax considerations into account to maximize their returns. Imagine if you could buy a stock make money in it, sell it buy more of another stock you thought would do well and didn’t have to pay any taxes until you decided to take your money completely out of the stock market? You can’t do that there but in real estate anywhere in the US you can do that everyday. This 1031 exchange rule really can make you a LOT of money when you realize how to correctly apply it and become a good real estate investor. Being a good real estate investor comes down to buying good properties, at good prices and then managing them well to obtain good rates of return given the marketplace.