Tax Deferred Exchanges and Financial Leverage

Tax deferred exchanges create a significant advantage for parties who own investment property, particularly when they have a large amount of equity. Essentially an exchange allows the owner to reinvest in a larger property while deferring capital gains. The transaction involves an exchange facilitator who holds the proceeds from the sale and then transfers those proceeds to escrow for closing on the replacement property.  Investors who are trading up should always utilize a 1031 tax deferred exchange.   The exchange must be planned in advance and the purchase and sale on the relinquished property should be assignable on the sellers side. Find out more about 1031-exchanges

Financial leverage in Real Estate allows one to gain appreciation on borrowed funds. This is the fundamental concept behind gaining wealth thru real estate investments. It is best explained by example. The return on investment decreases as equity increases.

Suppose property owner #1 and owner #2 both own properties worth roughly $300,000 and the rate of appreciation is approximately 5%/year.    Property owner #1 just purchased his property with a down payment of $30,000.  Property owner #2 owns the property outright.   Assuming a 5% appreciation rate the value on each property increases by $15,000/year.

Property owner #1 realizes a return on his investment of $15,000/$30,000 or 50%.

Property owner #2 realizes a return on his investment of $15,000/$300,000 or 5%

While this example is extreme, it illustrates how the return on investment is higher when the property is leveraged.

Suppose property owner #2 sold his property and purchased a $1 million dollar apartment building with 30% down.  Assume he used a 1031 exchange to defer paying any capital gains.   Assume the market is strong and that demand is good and in 12 years, the $1 Million dollar purchase is now worth $2 Million.   Compared to the alternative of holding the original investment, owner #2 realized a substantially higher gain.