How Does Depreciation Work?

1031 Exchange

Posted By: Pat Nelson / Jul 03 2017

Anyone who owns rental properties that have significantly appreciated in value and is now looking to take advantage of those gains should become familiar with the 1031 Exchange.

A 1031 Exchange, also called a like-kind exchange or a Starker exchange, allows a property or a business owner to defer capital gains taxes incurred on the sale of a property as long as that money is invested in another property or properties. A 1031 Exchange is applicable only for investment or business property, not personal property.

“That’s what makes it such a powerful investment tool,” Brian Nelson, principal and co-founder of Nelson Brothers Professional Real Estate, says in the latest installment of the “Ask the Brothers” video series. “Institutions and guys like Donald Trump and Sam Zell – big real estate moguls – have been leveraging the benefits and power of the 1031 Exchange for decades and accumulating and amassing large sums of wealth.

“And we think it’s one of the most underused investment tools by mom-and-pop investors. One of the things we want to do is help them find different options and different benefits where they can leverage the power of the 1031 Exchange to find investments that are better aligned with what they’re looking for.”

According to a 2015 study, “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate” authored by David Ling of the University of Florida and Milena Petrova of Syracuse University, that analyzed more than 1.6 million real estate transactions over an 18-year period, multifamily-related sales recorded the highest use of like-kind exchanges based on both unit and dollar volumes.

One of the study’s key findings was that, on average, taxpayers using a like-kind exchange acquire replacement property that is $305,000-$422,000 more valuable than the relinquished property, while replacement properties without using an exchange are cheaper or of equal value.

But, still, the most important benefit of the 1031 Exchange is tax deferral.

“A 1031 Exchange is unique in that it’s one of the only areas outside of an IRA where you can potentially defer your capital gains tax indefinitely,” Nelson said.

Property owners with highly appreciated real estate can sell those properties and, instead of paying perhaps hundreds of thousands of dollars in capital gains taxes, can invest that money in turnkey properties that will generate greater monthly cash flow.

For example, Nelson says, people who invested in real estate 20 or 30 years ago have undoubtedly made a lot of money through appreciation. If a property owner has $1 million in equity, he or she could potentially put that money into three or four different properties, earn an income of $65,000 to $75,000 a year, and in many cases not pay a dime in taxes on that by deferring through depreciation.

Property owners who were previously looking for growth and appreciation might now be more interested in stability and tax savings.

“And that’s where Nelson Brothers can help by repositioning and re-strategizing what their core objectives are, by making sure we’re aligning what is likely a sizable portion of their net worth or their nest egg and moving it into things that are really more aligned with what they’re looking for,” Nelson said.

“That’s why Nelson Brothers tends to focus on assets that are very stable and that are consistently producing an income – because we feel that that aligns with what a lot of folks are looking for today.”

Additionally, the 1031 Exchange is also a powerful estate preservation tool. When you pass away, your heirs will inherit the “exchanged” property on a stepped-up basis, which means at fair market value at the time of death. Essentially, this means that your heirs will not have to pay any tax on the gain that you deferred.

“One of the best factors of the 1031 Exchange is the stepped-up basis,” Nelson said. “If you’ve owned real estate for 40 or 50 years and it’s appreciated tenfold, and you’re able to do a 1031 Exchange and you pass away, your heirs inherit it on a stepped-up basis. What that means is that you’ve deferred all capital gains and depreciation recapture taxes indefinitely. That’s fantastic!”