Why a 1031 exchange instead of a sale?

There are many reasons for people to consider exchanging their property, rather than a sale. It’s not possible to cover them all in one article, so, at this time I’d like to give you a perspective I think is very important, short term and long term. That perspective is a comparison between selling investments and reinvesting, versus exchanging an investment for another investment. The results speak for themselves.

To set things up for this demonstration, I need to discuss tax terminology. The term gain is tax talk for profit. Gain is the difference between the cost of your property and the price received when you transferred your property to another party. The cost of your property creates, in tax talk,your basis in the property. Basis is adjusted by depreciation and capital improvements to the property. Depreciation reduces your basis, while capital improvements raise your basis. The result is called adjusted cost basis. This is a very important factor in any calculations prior to putting your property on the market. There are two kinds of gain. Realized gain is the gross profit. Recognized gain is the gain you pay tax on. In a sale the realized gain and the recognized gain are the same. In a tax-deferred exchange, realized gain is profit , but there is no recognized gain, therefore no taxes. You get to keep your profit and have it still working for you in your new investment.

One other advantage in real estate investing is leverage. The prudent use of leverage allows investors to acquire properties that may be four or five times as valuable as their investment. This will be illustrated in our example. If the return on your investment is greater than the interest rate paid on financing, it means you’re making money on someone else’s money. Having depreciation as a deduction, a paper loss rather than an actual loss, raises the return you’re receiving on your leveraged investment. That calculation isn’t considered in the comparison.

As you can see, exchanging results in faster estate building. Exchanging is beneficial in all transactions where you have a realized gain.