Investing in real estate is a great way to build assets and wealth because you access many financial tools in the process.
- Equity appreciation
- Cash flow
- Tax deductions/depreciation
- Debt pay down
One of the biggest tools of a savvy real estate investor is the utilization of tax deference on Capital Gains. We all know that income derived from a job’s paycheck has a healthy nibble taken out by the IRS. If you are already a real estate investor, you know that there are other ways to produce income that are in a much lower tax bracket.
But what happens when you want to sell that property? If you bought a property 5 years ago for $100,000 as an investment, and now recognize that you own a $250,000 property, you’re sitting in a great position to sell, right!? Maybe. Depending on your goals and how you want to structure it.
If you sell that property just to collect the check and utilize that capital, you will likely be subject to Capital Gains tax. Depending on your state, and income bracket, this percentage can vary. I will use 25% (Texas) for this example.
- $250,000 (sales price) – $100,000 (purchase price) = $150,000 (gain)
- $150,000 (gain) X 25% (capital gains tax rate) = $37,500 (tax burden)
- $150,000 (gain) – $37,500 (tax burden) = $112,500 (final profit)
Not bad at all. That is a hefty return on investment, and in this particular example means you did a lot of things right. You bought the property “right” at a smart value, and sold it when your equity position was very healthy. If you had another use or need for this capital, paying the taxes and accessing the money is great.
But if wealth and asset building is your strategy and goal, there is a great financial tool to utilize in the 1031 Tax Exchange. The 1031 Exchange allows a property owner to sell their property and use the gains as part of the acquisition of a new “like kind” property, which just means you must trade investment property for investment property. You can trade a single family rental for a 5 unit apartment, for a piece of raw land, for a storage property etc. When you do this, your equity continues to build and you can move your capital to more productive assets without ever paying capital gains tax.
Here is a 20 year example of the productivity of 1031 Tax Exchange using the same property above as a starting point. And this is also assuming the investor is buying value add properties under market value. And that an exchange is performed every five years.
- Initial purchase: with $25,000 down on $100,000 house.
- Five year hold and sale: $250,000 (sales price) – $100,000 (purchase price) = $150,000 (gain)
- Second purchase: an undervalued quadplex bought for $400,000 with a $100,000 down payment and $50,000 invested into improvement.
- Five year hold and sale: $600,000 – $450,000 (purchase + improvements) = $150,000 equity gain
- new equity position $325,000
- Third purchase: 10 unit apartment bought turnkey for $1,200,000 with a $325,000 down payment and $100,000 left for maintenance improvement.
- Five year hold and sale: $1,600,000 – 1,300,000 (purchase + maintenance) = $300,000 equity gain
- new equity position: $625,000
- Fourth purchase: 100 unit mobile home park for $2,000,000 with down payment of $625,000
- Five year hold and sale: $2,500,000 – $2,000,000 (purchase) = $500,000 equity gain
- New equity position: $1,125,000
- Fifth purchase: 50 unit Class A apartment complex for $3,000,000
So over 20 years, when ran properly, one’s initial investment of $25,000 into a single family rental compounded and exchanged up into $3,000,000 apartment complex with over a million dollar equity position.
If you are interested in buying your first investment property, give us a call, we would love to help you get started. If you already own an investment property and are interested in selling it, give us a call, there are many strategies we can help you with.