Besides deferring the tax, what are other reasons to do a 1031 exchange?
A: While many investors turn to a 1031 exchange because they don't want to pay the tax, few stop to consider the wealth building potential this tool offers. By deferring the tax and keeping your equity working, you gain the benefit of compounding your money. Einstein was purported to have said, "The most powerful force in the universe is compound interest." This fact, along with deferring the tax due on a sale indefinitely, makes a 1031 something that should always be considered when selling investment property. By catapulting 100% of your equity forward to be multiplied by the universal law of compounding, many a millionaire has been made.
To illustrate, just look at what happens when two investors own identical properties that have appreciated and are currently worth $1 million. Investor A decides to sell and use a 1031 exchange to purchase another property worth $1 million, deferring all taxes due. Investor B decides to sell and pay the tax due of $140,000, and one year later invests his remaining $860,000 in an investment property. To keep things simple, let’s assume both properties earn 5% per year, and that all earnings from the properties are deposited in a bank account that earns 2% per year. (For simplicity sake, we will also assume no appreciation of the property values.)
After 5 years, Investor A’s investment in her property and earnings account approximates $1,260,000, an increase of about $223,000 over Investor B’s “wealth” in his property of $1,038,000. The difference between the two investors’ positions in year 10 has grown to approximately $268,000, in year 15 to $318,000 and finally, over 20 years to $373,000. Investor B has lost out on 37% of his original $1 million sale due to compounding and the failure to use a 1031 exchange.
In summary, a 1031 can accomplish many investment objectives besides simple tax deferral. However, none may be more powerful than wealth building when combined with the universal law of compounding.