When it comes to real estate investment strategies, Section 1031 and 721 exchanges offer an attractive opportunity for investors seeking to maximize real estate investment potential.
1031 and 721 exchanges are powerful tax-advantaged tools that may allow for the deferral of capital gains taxes on the sale of real property used for business or investment purposes.
To illustrate the impact this can have on long-term returns, let’s walk through a hypothetical scenario comparing two common paths: taking sale proceeds in cash (and paying taxes) versus reinvesting all sales proceeds in a 1031 or 721 exchange, and deferring taxes.
Imagine an investor purchased a property long ago for $100,000 with no mortgage or other debt. They depreciated that property over time down to a zero adjusted cost basis. They are now selling that property for $1,000,000.
The up-front costs and expenses of an investment in a DST are not reflected in this example. Source: https://taxfoundation.org/data/all/state/state-capital-gains-tax-rates-2024/
Cashing Out: The Tax Hit
In the above hypothetical example, if the investor chooses to take the cash and pay the taxes, they will owe taxes on the capital gain of $900,000 and depreciation recapture on $100,000. Together, federal capital gains, state capital gains, Medicare surtax, and depreciation recapture result in a nearly $300,000 tax bill, leaving them with just over $700,000 to reinvest.
Using an Exchange: Full Reinvestment
If the investor opts to execute a 1031 or 721 exchange, the full $1,000,000 in sale proceeds can be reinvested. No capital gain, depreciation recapture, or Medicare taxes are paid at the time of the exchange.
Long-Term Impact: 10-Year Appreciation
Let’s say the new property appreciates at a modest four percent annually over a 10-year period. in this hypothetical example, thanks to the full $1 million reinvestment via the exchange strategy, it is estimated that the investor will gain nearly $500,000 more in value than the non-exchange path.
The government will always get a cut, utilizing a 1031 or 721 exchange strategy provides the opportunity to delay any tax burden — potentially growing wealth significantly at the same time. Before making any decisions, investors should consult with a tax advisor to understand how an exchange could fit into their investment strategy.