Tax savings from a 1031 exchange can be substantial. A 1031 exchange can be a great way to defer capital gains taxes, diversify your portfolio, and there’s a potential to grow your wealth through investment in high cash flow real estate. By doing a 1031 exchange, you can purchase replacement property, passive income potential, manage risk, and defer taxes.
Striving to maximize cash flow is key in real estate investing, and it starts with fully understanding and projecting your property’s income and expenses. Let’s say you purchased a rental property in 1980 for $150,000, and it’s free and clear of debt and appreciated significantly. Today, it’s worth $2 million, and the taxpayer has three options: keep it, sell it and pay some hefty taxes, or do a 1031 exchange. You need to understand cash flow potential to get the best return on investment.
Calculating Cash Flow
We’ve gone into depth about how to determine cash flow potential, but we’ll use the example above to show how a 1031 exchange can be used in an attempt to increase cash flow in real estate investments.
Most U.S. residential rental property depreciates at a rate of 3.636% each year for 27.5 years. The property bought in 1980 has passed the 27.5-year mark and is no longer eligible for annual depreciation deductions on your tax return. After insurance, property taxes, and repairs and maintenance fees are taken out, the property generates a net rental income of $4,000 per month. An annual income of $48,000 on your investment property valued at $2 million gives you an annual return on investment of only 2.4%. The cash flow is low; however, your investment in a single asset has grown astronomically.
To pursue the best return on investment, you can do a 1031 exchange into another property for full tax deferral with higher cash flow projections and long-term appreciation potential. Or, you can release some equity and receive part of the sales proceeds from the relinquished property and do a 1031 exchange to defer paying capital gains on the remainder of the proceeds.
What Factors Determine Cash Flow?
Many factors determine cash flow potential on a residential rental property. Factors that hurt cash flow include:
- Maintenance and repairs
- Missed rent
- High turnover rates
- Property taxes and insurance
Factors that can potentially increase cash flow are:
- Increasing rent
- Preventative maintenance
- Improvements and renovations
- Long-term tenants
- Appealing property tax
The One Percent Rule
The one percent is a general guideline used by real estate investors to determine if the monthly rent from a residential or commercial real estate property will exceed the property’s monthly mortgage payment. This rule works by multiplying the purchase price of the property plus upfront repairs by 1 percent. This gives you an idea of how much monthly rent should be on your property. This should only be used as a guideline and not as a fundamental rule to determine the potential gain and risk in an investment property.
Boosting real estate property cash flow creates an opportunity to reinvest your assets and strive for a great return on investment. Taxpayers can exchange into like-kind properties with high cash flow potential and put off capital gains tax with a 1031 exchange. Before jumping in, go over your goals with your qualified intermediary to develop a strategic plan for your 1031 exchange high cash flow real estate investments.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
There is no guarantee that the investment objectives of any particular program will be achieved. Property cash flow is not guaranteed and may vary.
The 1031 Investor's Guidebook
Tackle the art and science of completing your 1031 exchange.