Case Study: How a 1031 Exchange Helped Our Client

By November 21, 2022 No Comments

1031 Exchange SylvanOne of our clients performed a 1031 exchange with their investment property, allowing them to defer their capital gains tax!

At Sylvan Financial Advisors we’re always looking for ways to help our clients find tax-advantaged solutions for their financial issues. That means familiarizing ourselves with effective, commonly used strategies that can help you keep more of the money you’ve worked so hard to earn.

In one instance, we orchestrated a 1031 exchange for a land-owning client looking to cut their tax obligation on a property with significant gains on the investment. Luckily, that’s just what a 1031 exchange is designed for. It allows real estate investors and property owners to swap one property for a like-kind one, thereby deferring capital gains taxes.

There are, however, strict rules that must be followed to properly execute your exchange if you think it may be the right move for you. Let’s quickly go over the process and the effects it had on our client.

The Situation

After a lengthy career of building what they hoped was a safe and secure nest egg for retirement, our client was looking to call it a career very soon and begin chasing their dreams. They were also looking to build another stream of income that would help them through retirement and give them a consistent source of funds to support their lifestyle. As we do with all of our clients, we looked at their unique situation to determine what we believed was the best course of action. We knew that they were current owners of a real estate property from which they were taking depreciation, and we knew they wanted to consolidate their portfolio in preparation for retirement.

The 1031 Exchange

Based on the client’s circumstances, goals and desires, we believed that the most suitable action was to perform a 1031 exchange immediately after selling their real estate property. With the property’s appreciation in value, we fully expected that an outright sale would mean that the client would face significant capital gains taxes upon closing, potentially forcing them to foot a bill that could reduce their available retirement income.

As anticipated, the client incurred capital gains taxes by selling the property, which could have drained a healthy portion of their gains on the investment. Instead, with our assistance, the client executed a 1031 exchange by using the property sale proceeds to purchase a like-kind property, which according to the IRS is simply a property of the same nature regardless of grade or quality as long as the value is equal to or greater than the fair market value of the relinquished property. (NOTE: You must also reinvest all of the net cash received at the closing of the relinquished property into the replacement property.)

The process is tricky in that the IRS dictates that the new like-kind property be designated as a replacement property within 45 days then be closed on within 180 days of the original sale, so it’s important that any 1031 exchange be handled carefully and quickly.

How the 1031 Exchange Helped the Client

By performing the 1031 exchange and acquiring a new investment property, our client deferred the taxes on capital gains until the future sale of the new property. They also acquired an attractive new monthly source of income by purchasing a new rental property, giving them a stream of funds to help them reach their goals in retirement.

Had they not executed the 1031 exchange and simply sold their property, they surely would have walked away with a lump sum of cash, but that lump sum could be taxed at the capital gains rate of up to 20%, or more if the asset had been held for less than a year. They also would not have added a stream of income to eventually figure into their monthly budget and provide them with earnings they could use for living expenses or retirement luxuries.

Additionally, if the client decides to bequeath the property to a beneficiary, the cost basis is stepped up to the current value of the property at the time of their passing. This means that beneficiaries would only see capital gains taxes on the gains made after inheriting the property. Thus, the client saw an immediate impact by deferring capital gains taxes, potentially forever. And if their property is passed on to a beneficiary, the heir will also save on capital gains taxes by inheriting the property at its current market value.

Could it be the Right Decision for You?

A 1031 exchange was able to offer our client tax deferral on the sale of their property, a newly created source of income and tax advantages for beneficiaries set to inherit their estate. That said, it’s important to know the rules of a 1031 exchange and how it could impact your unique situation. We’d also always recommend consulting a financial professional who understands how the exchange works and can help moderate and facilitate the process, either by themselves or through connections.

If you have any questions about a 1031 exchange or creating an estate plan, please give Sylvan Financial Advisors a call at (201) 282-5332.