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.