Tax relief is the number one reason real estate investors complete a 1033 exchange, how does this strategy help to grow the net worth of these investors? This is best illustrated in the following real-life example.
Twin sisters Elizabeth and Eleanor, buy real estate to produce monthly income. So, it makes sense that the more real estate each owns, the more income each receives. However, the two disagree on when taxes should be paid. Elizabeth believes that taxes will rise in the future so she incorporates a policy of “pay-as-you-go.” Eleanor likes the 1031 Exchange strategy.
The difference of taxation impacts wealth-building.
Each receives a 5% capitalization rate (NNN)
Elizabeth’s pay-as-you-go policy:
Purchase Price | Downpayment | Sale Price | Tax | Net Worth |
$250,000 | $50,000 | $350,638 | $20,544 | $80,094 |
$400,470 | $80,094 | $561,680 | $32,909 | $128,301 |
$641,505 | $128,301 | $899,744 | $52,717 | $205,522 |
$1,027,610 | $205,522 | $1,441,276 | $84,446 | $329,220 |
$1,646,100 | $329,220 | $2,308,740 | $135,272 | $527,368 |
An investment that grows from $50,000 to $527,368 over 25 years has an internal rate of return (IRR) of 12.5%. That’s the power of leverage and compounding.
Over the 20 years of investing, Elizabeth received $991,421 in net rental income. However, she paid $325,888 in federal income tax (capital gains plus depreciation recapture) on the sales.
Eleanor’s 1031 Exchange strategy:
Purchase Price | Downpayment | Sale Price | Tax | Net Worth |
$250,000 | $50,000 | $350,638 | -0- | $100,638 |
$503,190 | $100,638 | $705,750 | -0- | $202,560 |
$1,012,800 | $202,560 | $1,420,504 | -0- | $407,704 |
$2,038,522 | $407,704 | $2,859,133 | -0- | $820,611 |
$4,103,054 | $820,611 | $5,754,745 | -0- | $1,651,391 |
Her $50,000 investment grows to $1,651,391 over 25 years and has an internal rate of return (IRR) of 19.1%. That’s the power of leverage, compounding AND tax-deferral.
Over the 25 years of investing, Eleanor received $1,976,892 in net rental income and she paid no federal income tax on the sales.
However, she still owes the tax. She can sell her property and pay all the tax back to day one. If so, her tax bill would be $320,278 in capital gains tax and $329, 482 in depreciation recapture. Eleanor would retain an after-tax net worth of $1,001,631. That’s 90% more than her sister!
Instead, Eleanor chooses a highly leveraged DST as her next replacement property. She believes in the “Swap ‘til you Drop” philosophy because, when she passes away her heirs will receive a step-up in cost basis which is the cornerstone of legacy planning.