1031 Exchanges – How And Why?

How can the 1031 Exchange affect the decision to sell? 

The following is a hypothetical example designed to illustrate why a 1031 exchange would be worth considering:

Let’s say Mary’s family has owned a 100-acre farm for more than one generation. Selling land can be a tough decision for a family, but this example can define how the 1031 exchange can influence the decision to sell.  

The concept of Cost Basis and determining what the family’s cost basis actually is, will be a crucial component in determining whether or not, and to what extent, the 1031 exchange benefits the family, financially. Let’s assume the family in our example has a cost basis of $0.00. The next factor that needs to be understood is what the family’s annual expenses are in owning the farm. Property tax can often be a considerable expense. Other expenses might be associated with the maintenance of the property. If the property generates any income, this needs to be taken into account, as well. The annual net income or expense associated with the farm needs to be understood so that it can be compared and contrasted with the prospect of a replacement property. 

To demonstrate, assume the family has an average net income of -$5,000 for the last 3 years. Now, let’s say the family has is a bona-fide offer to sell the property for $1,000,000

The concept of capital gains and the current rate for federal capital gains tax needs to be understood. Simply put, capital gains are the difference between the cost basis and the profit or net proceeds of the sale. In our example, the capital gains would be $1,000,000 Capital gains tax would be assessed against the $1,000,000 profit. If the current federal rate was 25%, that would amass to a tax liability of $250,000 The family would be left with $750,000after taxes.

If the family replaced the farm with an income producing property, using the rules laid out in section 1031 of the tax code, the net proceeds of $1,000,000 would be re-deployed without paying the capital gains tax.  Right away, the family has 25% more purchasing power if they deployed the “after tax” proceeds of the sale.

Assume the family purchases a replacement property with a Net Operating Income (NOI) in place of $70,000. Every year the family now has $70,000 of income (taxable) where they had a loss of $5,000 each year associated with owning the farm. After 5 years, this difference would amount to $375,000. The family also still owns a property, presumably still worth the amount they paid for it, $1,000,000 The result is a win-win for cash flow and investment. As exampled above, it is clear that many other factors can and will affect your specific scenario.  Assembling a solid team of professionals, each with specific areas of expertise can put your family ahead.