1031 Tax Deferred Exchange Economies of Scale

1031 Tax Deferred Exchange Economies of ScaleGiven the asset sale is a taxable event and the taxpayer’s intent is to replace with a like-kind asset, a 1031 tax deferred exchange results in the efficient use of the dollar through economies of scale. Maximizing the marginal use of the dollar is the core principle in a 1031 tax deferred exchange, rather than paying the capital gain tax. Economies of scale is a microeconomics term used to describe reductions in unit cost as other cost contributing factors decrease. Relative to a 1031 exchange, the cost of capital decreases as the return on capital may increase over time.

Economies of Scale

In a 1031 tax deferred exchange, real or personal property held in the productive use of a trade, business or investment are replaced with like-kind real or personal property to be held in the productive use of a trade, business or for investment. When the Internal Revenue Code Section1031 Regulations are followed, no gain or loss is recognized; the tax is deferred.

For example, when a cell tower or commercial building is sold for a higher price than the original purchase price, plus the improvements less the depreciation, the adjusted basis increases. The sales price less the adjusted basis and selling expenses results in a realized gain. This amount is then taxed by the taxpayer’s state and federal tax brackets in addition to a 25 percent recaptured depreciation tax. The tax can represent 40 percent of the sales price. Given an asset that does not typically appreciate but is depreciated, such as a business aircraft, the recaptured depreciation tax due upon sale can be a five and six figure number.

When the aircraft, cell tower or commercial building is replaced with like-kind property of equal or greater value, the tax is deferred, delayed or postponed until the time the replacement property is sold. This could be less than one year or much longer. By not paying the tax, the horizon those otherwise paid out dollars are continued to be utilized to generate cash flow, appreciate, depreciate, diversify, consolidate or relocate the replacement asset to improve operating efficiencies, which is the outcome of economies of scale. Extending the time those respective tax dollars are utilized can result in a higher return given the asset is:

  • located in the path of progress and appreciates
  • adds girth or tangible board feet in a timber tract
  • occupancy rate in a multi-family unit improves, generating a higher capitalization rate
  • asset is depreciated, such as a business aircraft or leased equipment, offsetting income tax
  • meeting or fulfilling the taxpayer’s expectations

1031 Tax Deferred Exchange

The Internal Revenue Code Section 1031 tax deferred exchange is effectively an indefinite interest free loan from the federal and state governments that incentivizes the sale and purchase of replacement assets. The main risk is that the capital gains taxes will be higher in the year the 1031 exchange is reported with the taxpayer’s federal tax return. Additional risks include mother nature, economic disasters, such as the Great Recession and global debt crisis, or ultimately, expectations did not meet reality.

The cost advantages of utilizing a 1031 tax deferred exchange allows the cost of capital to fall as the return on capital increases. Taking a long term view of holding and monitoring an asset against goals or metrics such as rate of return, capitalization rate or use efficiencies represents a prudent strategy. If it is determined that the asset is not fulfilling the goal or to realign with the revised investment strategy, the 1031 exchange allows for the asset to be replaced with a like-kind asset and continuing the deferral while incurring selling and closing costs.

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