Use Innovation to Make Your House Work for You

Utilizing the 1031 tax deferred exchange to build your wealth

What do all three of the following deals have in common?

  1. Our client purchased their home in 1965 for $73,500 and sold it through Equity Advisors for $6,350,000 in 2017.
  2. Our client purchased their home in 1986 for $725,000 and sold it through Equity Advisors for $3,725,000 in 2017.
  3. Our client sold their rental home and purchased NNN and multifamily investment properties through Equity Advisors totaling $8,129,000 in 2017.

If you answered that Equity Advisors handled all of these transactions in 2017, you would be correct. However, the more interesting commonality is that all of these deals had a 1031 tax deferred exchange as a catalyst to make them happen.

For those of you not entirely sure of what a 1031 tax deferred exchange is, I’ll summarize. The IRS created the 1031 to accommodate those clients that want to sell one investment property and buy another. When this sale and purchase of investment properties is done following a set of guidelines outlined by the IRS, the result is that there is no tax due at the time of the sale of the relinquished property (downleg) and the purchase of the replacement property (upleg). Mind you, this does not mean there is no tax due; rather, it is deferred. However, even if you sell the upleg property at some point in the future, as long as you buy another replacement property, the tax continues to be deferred indefinitely.

The power of the 1031 tax deferred exchange is significant. In the three deals cited at the beginning of this article, there are literally millions of dollars that would have been owed to the IRS. Instead, those millions of dollars are now at work for our clients, earning them hundreds of thousands of dollars in income annually.

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In the first example above, our clients purchased multifamily properties that generate a $400,000-plus stream of cash flow on an annual basis. I won’t bore you here with example after example of how this has changed our clients’ lives. However, when we say, “Our clients are happy. So, we are happy,” this is one of the reasons why.

The power of the 1031 tax deferred exchange is significant. In the three deals cited at the beginning of this article, there are literally millions of dollars that would have been owed to the IRS. Instead, those millions of dollars are now at work for our clients, earning them hundreds of thousands of dollars in income annually.

My House Is Not an Investment…or Is It?

An investment property, by definition, is one that generates cash flow, not depletes it. Your house has probably actually been a significant drain of your cash flow for years, correct? Mortgage payments, taxes, repairs/improvements, etc. Thankfully, it probably has appreciated, but how do we “flip the switch” and make your house work for you instead of the other way around?

The first step to your house becoming an investment property is we rent it out for you. Although there is no clear-cut answer on how long you need to rent out your home for it to be considered an “investment property,” most CPAs and attorneys agree that at least one year should suffice. Does it sound like a hassle to rent out your home? Perhaps. Does it sound nauseating to write a check to Uncle Sam for six or seven figures? Definitely!

Let’s work through a quick hypothetical of how one home sale may look with a “standard” sale versus a “1031” sale.

Assume we sell your home for $2M. (For the sake of this example we will assume you have no debt on the home.) You purchased your home 20 years ago and your basis (what you paid) is $500,000. You get a tax exemption of $250,000 if you are single and $500,000 if married, assuming you have lived in the home in two of the last five years. (At the time of this writing nobody knows if the new tax plan will affect these exemptions.) Assume you get the married $500,000 exemption along with the exemption of your basis of $500,000. You net $1,875,000 (after expenses such as commissions, closing costs, etc.) less your $1M in exemptions. So, capital gains tax is due on the other $875,000 at roughly 35% (25% federal and 10% state). You get to write a check to the IRS for $306,250!

Now, let’s handle this transaction with a 1031 exchange. First, we need to rent the house out for at least a year. Let’s say that generates $5,000 per month in rent. Most of our clients will simply rent another home for themselves for the same (or less) amount of rent. It’s a bit of “trading money” for a year, but it will pay off in the long run.

So, now the home has been rented for the appropriate amount of time and we sell the home for $2M. Minus expenses, you now have $1.875M to invest into an upleg. The replacement/upleg property can be any kind of investment real estate including: apartment buildings, retail/NNN deal, office buildings, industrial property, etc. Let’s say Equity Advisors helps you find a NNN deal backed by a strong national retailer with a 15 year lease. The deal is purchased for a 5% capitalization rate (meaning rate of return excluding any debt service.) Thus, the $1.875M property will generate a 5% return or roughly $93,750 per year in cash flow after expenses.

Consequently, the standard sale required you writing a check for $306,250 to the IRS. In the 1031 scenario, you are receiving a check for $93,750 per year (and probably increasing every couple years) for the next 15 years and your entire $1.875M is intact and invested in the replacement property.

Your Situation

In conclusion, every client has different needs. Sometimes a standard sale, where the client pays the tax due and walks away with the balance of the proceeds, is the best scenario for the client and their family. For instance, often our clients are selling their house to use the proceeds to buy another home. The 1031 exchange is just one option that we can utilize to help serve clients as needed.

We welcome the opportunity to sit down with you and discuss any questions you may have relating to the sale or purchase of a home. At Equity Advisors, we pride ourselves on handling every transaction with an uncompromising commitment to excellence and attention to detail.