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Leverage
Robert Calongne • October 4, 2020
Explode your 1031 Exchange Profits with "Leverage"
Who said "Compound interest is the eighth wonder of the world. He who understands it earns it… he who doesn’t… pays it.”
-The saying has been attributed to many so why not use it now?
Commercial brokers and investors in income producing commercial properties have "tools" to analyze property performance. A good one is called an "APOD" (that stands for, "Annual Property Operating Data") that is designed to address the two major investor questions:
- How much money will be required to acquire it and operate it and
- How much money will it generate when it's sold after a period of time, for example in 5 years.
They want to know the up-front cost, the annual cash-flow (or cash-drain) before and after debt service and taxes, then the estimated return for that investment on sale after loan pay-off and taxes. The typical rates of inflation used in such analyses are as follows:
"Best Case" scenario assumes 7.00% annual appreciation"Moderate Case" scenario assumes 4.50% annual appreciation"Worst Case" scenario assumes 2.50% annual appreciation
Those are certainly neither predictions nor limitations but, rather, they are the initial estimates used by the pros.
Now, obviously if you buy property with all cash, then sell it in 5 years, your investment per the table below) would be returned plus an extra 13.14% (worst case) to 40.26% (best case).
Appreciation Grows to Return on Return onScenario Rate/Year In 5 years All Cash 30% CashBest Case 7.00% 40.26% 40.26% 234.18%Moderate Case 4.50% 24.62% 24.62% 182.06%Worst Case 2.50% 13.14% 13.14% 143.80%
But with "Leverage' your returns EXPLODE because you use the same cash with a loan to buy much more valuable property that appreciates. Moreover, the extra tax-savings "seed money" with a 1031 Exchange "supercharges" your profits.
For example, say you have $120,000 net proceeds from the sale of business or investment real estate after taxes (of let's say $30,000) to "invest" for an all cash
purchase of other such property. The $120,000 property you acquire could appreciate in
value after 5-years
at 4.50% annually to
$149,542. That's
24.62% more
than the $120,000 invested.
But had you used the same $120,000
as a leveraged down payment
on a 30% loan to value (LTV) mortgage, the loan
amount of $280,000 could buy property for $400,000. That property could appreciate in value after 5-years
at 4.50% annually to $498,473. That's enough to pay off the loan to net $218,473, that is 82.06%
more than the $120,000 originally invested.
Now combining that leveraged example above with a 1031 Tax-Deferred Exchange,
the tax savings would add an extra $30,000
to what otherwise would have been only $120,000 in sale proceeds so you could make a down payment of $150,000
on a 30% loan to value (LTV) mortgage, the loan could be $350,000
to buy property for $500,000. That property could appreciate in value after 5-years at 4.50% annually to $623,091 Then you pay off the loan and net $273,091. That's 127.58%
more than the $120,000 you otherwise could have invested. The extra "$30,000 seed" resulted in your nearly tripling that $120,000, a hefty average return of 45.5% per year.
And, by the way, if you later "sell" the property you acquire (that "replacement property") there would be tax on your capital gains. But not only would you use "future, less valuable dollars" to pay the tax then there are, indeed, several alternatives that are not taxable--one example would be another 1031 Exchange.
The 1031 Exchange Center Tips
Are you a real estate investor looking for ways to optimize your tax position while expanding your property portfolio? One powerful strategy at your disposal is the partial exchange transaction, a key component of a broader concept known as a tax-deferred exchange in real estate. We as an intermediary in this field, will delve into the world of partial exchange transactions, shedding light on how they can benefit your real estate investments. Understanding the concept A partial exchange," is a subset of a tax-deferred exchange in real estate , particularly under Section 1031 of the Internal Revenue Code. The primary goal of a partial exchange is to allow investors to defer capital gains taxes when exchanging one property for another. What sets it apart is that it permits investors to receive some cash or non-like-kind property (referred to as "boot") in addition to the like-kind property they acquire. How Does a Partial Exchange Work? A partial exchange follows a structured process: Identification of Properties: Just like a standard 1031 exchange, the process begins with the identification of the relinquished property (the property you're selling) and the replacement property (the property you're acquiring). This step is critical to the success of the exchange. Boot Consideration: In a partial exchange, investors may receive cash or non-like-kind property, referred to as boot, in addition to the like-kind property they acquire. The amount of boot received is taxable. Investors must decide how much boot they are willing to receive based on their tax strategy. Tax Deferral: The primary objective of a partial exchange is to defer capital gains taxes on the sale of the relinquished property by investing in like-kind property of equal or greater value, even if they choose to receive some boot. Benefits of a Partial Exchange Tax Savings: By using the partial exchange strategy, investors can defer capital gains taxes and allocate them towards the acquisition of a more valuable like-kind property. Enhanced Flexibility: The partial exchange allows investors to retain a portion of the sale proceeds in cash or non-like-kind property, offering greater flexibility in managing their financial resources. Strategic Investments: Investors can strategically choose properties that align with their investment objectives, even if it means receiving some boot in the transaction. Property Diversification: Diversification can be achieved by retaining some boot to invest in non-like-kind properties that complement their real estate portfolio. Key Considerations Investors considering this kind of tax-deferred exchange in real estate should keep the following considerations in mind: Tax Implications of Boot: While boot can provide flexibility, it's important to understand the tax implications of receiving it, as it may be subject to capital gains taxes. Identifying Replacement Property: Identifying suitable replacement properties within the IRS's strict timeframes is crucial to the success of a partial exchange. Qualified Intermediary: Working with a qualified intermediary like us is essential to ensure that the exchange complies with IRS regulations and guidelines. In conclusion, A partial exchange transaction is a valuable tool for real estate investors aiming to defer capital gains taxes while enjoying flexibility in managing their financial resources. By understanding how this strategy works and its associated benefits and considerations, investors can make informed decisions that align with their investment goals. When used diligently with the help of an intermediary like us, the 1031 Exchange Center, LLC a partial exchange can enhance your real estate investment journey and contribute to your long-term financial success. Contact us today to speak with our experts and get started on your path to tax savings and financial flexibility in your property portfolio. We're here to guide you through the process and help you make the most of your investments.
Are you a real estate investor looking to maximize gains while minimizing tax liabilities? If so, you've likely heard of a construction exchange 1031 , a powerful tool within the world of real estate transactions. As a qualified intermediary in 1031 exchange, we will attempt to explore the fundamentals of this strategy and how it can help you defer taxes through a deferred exchange while focusing on the construction 1031 exchange aspect.
A tax-deferred exchange does not mean you'll have to eventually pay the tax
The 1031 Exchange Center LLC is an IRS Qualified Intermediary that is not permitted to give legal or tax advice. Please consult with your legal or tax advisors concerning your specific case. But for a complimentary confidential evaluation, please click the button below.