One caveat about 1031 exchanges

[Robert Steele]

I've sold quite a bit of real estate and never done a 1031 tax deferred exchange. Not because I didn't know about it but because the timing just never seemed right. For instance if I am selling into a rising market that has been hot for some time I'd rather take that cash and pay tax on it with the thought of using it as capital for some other endeavor or to acquire more real estate later when the market cycles to a buyers market.

Anyway, so on to the caveat. While trying to console myself that I had done the right thing all those times I came to a realization that is so plainly obvious I wonder why I had never seen it before. Perhaps you have.

Every month that you pay down those mortgages you have to pay income tax on the principle. This is money that you never see until you sell. When you sell you don't pay taxes on that money a second time. So if I keep rolling over 1031 exchanges I will never see any of that income back that I have already paid taxes on. 

Now of course the devil is always in the details but lets assume you hold your properties for at least a year before you sell them (unless of course you like paying transaction costs). So by doing a 1031 I am saving long term capital gains taxes at 0%, 15% or 20%. However the income taxes I already paid on that principle pay down which is locked up as equity in the property I might have paid anywhere from 0% to 39.6%. Assuming I am in the top tax bracket that is 40% in income taxes I am paying to save 20% in capital gains taxes. Doesn't make much sense right?

Of course the amount of appreciation I am receiving is usually going to be more than double the amount of principle pay down. Or is it? Over the course of a 15 year note if I buy in at the top of the market I will probably have paid down more principle that the property has appreciated.

I am not saying 1031 tax deferred exchanges are bad. I am just pointing out that there are some caveats. It is not the holy grail that it is often touted as.

[Dave Foster]

@Robert Steele, you raise a very interesting question (to me at least since the response hasn't exactly overwhelmed the BP servers).

You're absolutely right.  The 1031 isn't appropriate for every situation.  You hint at that in your last paragraph but your first paragraph indicates that in all of your many situations the 1031 hasn't been right.   I never based a decision to sell or not sell on the impact of the 1031.  Rather I made a decision to sell and then looked at my current situation and strategic goals to see if the 1031 improved my situation or not.  If not I didn't do one.

I sense that the largest reason for your distaste of the 1031 is the notion you raise that you're paying tax on tax and a higher tax with the 1031 when you finally sell without a 1031 since you are taxed on rental income and then the part of that income that went to principle pay down is taxed again. I may be missing something.

1. First of all you can continue doing 1031s until you pass and never pay any tax.  If you want to stop yes you'll pay tax on your gain to that point.  But if you simply sell every time you're paying tax on the gain to that point anyway - it's just less because you haven't gained the benefit of time and compound return from being able to invest the tax dollars for your benefit as well.  

2. Equity never determines your taxable gain.  Taxable gain is based on the difference between your adjusted cost basis and the net sales price.  If you bought a property, depreciated, improved it and whatever and has an adjusted cost basis of $150K and then sold it for $250K you have a gain of $100K no matter what you owe on it.  If you used your net income (or more accurately your tenants) to pay down the mortgage to $0 you till have a gain of $100K even though the cash you receive is very different.  You're paying tax on all of that principle pay down as it comes in through net income.  You will not pay tax on it again.