The Tax Man Cometh: Deferring Taxation With a 1031 Exchange, Part 4

10341Successfully investing in real estate, like any other investment, requires making the most out of every penny. For many investors, this means taking advantage of tax strategies that allow them to defer tax liability on their capital gains in order to put that money to work earning - you guessed it - more money.


In the first three posts in this mini-series, we have explored all the intricacies of the 1031 like-kind exchange - it’s [structure], timeline, [rules and requirements], and how it impacts your [tax basis] in your new investment property. If you’ve made it this far, you’re probably wondering when we’re going to get to the really good stuff. Can you use the 1031 exchange more than once? Is there a way to use this tax-deferral method to permanently avoid paying capital gains tax?


Luckily, the answer to both these questions is a resounding “Yes!”. In this fourth post of the series, we’ll explore the first of two strategies for permanently deferring your capital gains tax liability.


Option One: Defer, Defer, Die

The first and most obvious option is to keep using consecutive 1031 exchanges to trade investment properties (and rack up a considerable tax bill) until you die.



There is no rule about how many exchanges you can execute. As long as you establish intent to hold a property for investment or business purposes and meet the timeline and documentation requirements, you can use the 1031 exchange process as many times as you like throughout your lifetime.


Under current tax law, any real estate that passes to your heirs upon your death receives a ‘stepped-up’ tax basis. This means that the property’s tax basis is increased to its fair market value (FMV) at the time of your death. When your heirs sell that property, they will only owe capital gains tax on any amount of profit that exceeds that amount.



To best illustrate the power of this strategy, let’s look at the impact of using the process multiple times throughout your lifetime.


For simplicity, let’s say you don’t make any substantial repairs or renovations on any of your properties, and that the IRS magically doesn’t care about depreciation. We’ll assume that the only variables are the price you pay for each property and how much value is rolled over through each subsequent 1031 exchange.


In reality, of course, depreciation definitely comes into play. For the purposes of this illustration, however, it’s not necessary to complicate things with reality. Just remember that, whether you take the depreciation deduction on your taxes or not, the IRS considers depreciation to be whittling down your tax basis every year - so take those deductions!

 ex4 1


If you were to stop here and resell property B right away at the same $300,000 value, you would owe taxes on that same $50,000. Your tax bill for A wasn’t eliminated, it was simply deferred.


ex4 2


ex4 3


After three consecutive exchanges, you have deferred taxation on $200,000 of capital gain. As long as you do not sell Property D outside of a 1031 exchange, you do not have to pay taxes on that profit. If you sell Property D for $500,000, thereby earning zero profit, you still would have to pay taxes on the $200,000 of deferred gain from Properties A-C. If you sell Property D for a profit, the amount of taxable gain is even higher.


Of course, if you sell Property D for $300,000 or less, you can avoid taxation on previous profit, but only because you lost it all in a very unsuccessful investment - which is not the result we want.


Death and Taxes

taxdebAs you can see, your tax liability does not disappear with a 1031 exchange, and the more you defer, the bigger your eventual tax bill will be.


But, if you die while still owning Property D, it will pass to your heirs and they will receive a ‘stepped-up’ tax basis equal to the fair market value (FMV) of the property on the day of your death. So, if you leave Property D to your child and an appraisal reveals it is worth $600,000 at the time of your death, your child receives that tax basis regardless of how much deferred gain was rolled into it during your lifetime.



Let’s assume the property can be sold for $650,000 and look at the difference a stepped-up basis can make:


ex4 4


By holding onto your property and leaving it to your child in a will or trust, you have successfully avoided paying capital gains tax on all the profits you earned from the sale of three sizeable properties. In addition, your child’s eventual tax burden is minimized effortlessly.


Of course, there’s no reason to stop at Property D. You can continue to execute consecutive exchanges up through Property Z if you want to, as long as you do not sell any property outside of an exchange. Since many people want to leave assets to their children anyway, this is a good strategy to help avoid taxation and gift a valuable asset to your heirs.


Another Option


Of course, not everyone wants to have to hold onto their investment properties forever. If it looks like the market might crash or your property could be losing value, you don’t want to have to keep betting on that losing horse until you die. Luckily, there is another option for permanently deferring taxation.


In our next post, we will explore charitable remainder trusts and how this specific type of financial arrangement can be used to avoid capital gains taxes indefinitely, while also reducing or eliminating your estate tax liability.


In the meantime, it might be time to hit the books. If you think a 1031 Exchange is something that would benefit you now or in the future, you need to make sure you have an experienced, professional Qualified Intermediary on your team. There are many, many great QIs out there, and you should do your own research to find one that understands your goals and has the experience necessary to help you achieve them.


1031If you’re excited to learn more but don’t know where to start, go ahead and check out Bill Exeter’s website over at Exeter1031.com.* Bill has a wealth of experience, and his company focuses entirely on the 1031 Exchange process. Most importantly, the Exeter1031 website is an amazing resource for free information about the 1031 process. Regardless of which QI you choose, we’d recommend perusing their site to broaden your understanding of this powerful tool.


And, of course, always feel free to [shoot us a message] any time if you have any questions about what you’ve read here, the benefits of a turnkey investment, or what we do at Spartan that makes us an industry leader.


**Spartan Invest does not have any financial affiliation with Bill Exeter or Exeter1031.com. We do not receive any commission or other financial benefits from our readers using their site or services.**










Lindsay Davis
Chief Executive Officer

Categories: Blog

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