This blog post was written by Paul Getty and Ray Simmons.
We often receive questions from clients asking us if it makes sense to forgo a 1031 exchange and invest the remaining after tax funds into a potentially higher yielding non 1031 investment such as dividend paying stock or fund versus investing exchange funds into a Delaware Statutory Trust portfolio.
In this blog post, we welcome the inputs of Ray Simmons whose firm, Exchange Planning Corporation, specializes in analyzing 1031 exchanges to optimize investor tax savings.
Leo Discovers What Boot Actually Costs on His $7M Sale
Scenario: Leo and his wife live in Washington state—no state income tax—and they've owned their building for more than 30 years. It's time to sell. The property is going for $7 million.
They don't need all the cash. This property is part of their legacy, something they want to pass on to their children. The goal is to grow it as efficiently as possible.
Leo has been studying his options carefully. His plan: exchange $2 million into DSTs through a 1031 exchange and pay the tax on the remaining $5 million (aka as “boot”). His thinking is that he could invest the after-tax proceeds at a higher targeted rate of return—enough to make up for the tax bill.
It's a reasonable theory. But does the math actually work?
Exchange Planning Corporation ran the numbers using their exchange planning calculators at 1031TaxHub.com to help Leo see exactly what each path would cost him. Leo's story is a good illustration of what these tools can do to help clients make informed decisions about the sale of their rental properties.
What Happens If Leo Doesn't Exchange at All?
First, Exchange Planning Corporation looked at the scenario where Leo sells outright with no exchange. The estimated federal tax: approximately $1.3 million.
Because most of Leo's gain would be taxed at the 20% capital gains rate, his overall effective rate comes in around 18.6%. On a $7 million sale, that sounds manageable as a percentage—but $1.3 million is still $1.3 million.
Here's what most investors overlook: the report also showed that Leo's current property isn't sheltered at all. He's earning an after-tax return of roughly 3% on the building. If he simply holds the property, he'd pay an additional $480,000 in taxes over the next five years just on the rental income. The building is generating income, but the tax drag is significant.
Leo has definitely decided to sell. But the question isn't whether to sell—it's what to do with the proceeds.
The "Pay the Tax, Invest at a Potentially Higher Return" Scenario
Leo's original plan assumed he could earn 9% on the after-tax proceeds from his $5 million in boot—fully taxable income—and beat what a DST portfolio would return at a assumed 4.5% annualized cash flow.
After 14 years in that scenario, Leo would have earned about $1,050,000 more in after-tax income compared to a full DST exchange.
Sounds like a win, right?
But Leo also paid $1.3 million in taxes to get there. After 14 years, accounting for the taxes paid upfront, he's still roughly $250,000 in the hole as compared to a full exchange. The taxes are what make it so difficult for another investment, even one that achieves a higher nominal return—to outperform tax-deferred real estate.
What a Full 1031 Exchange into DSTs Would Look Like
If Leo exchanged the entire $7 million into multi-family DSTs paying 4.5% cash flow, he'd receive approximately $300,000 per year in distributions—and potentially pay as little as zero income tax on that cash flow for at least the first five years, thanks to depreciation deductions which would potentially reduce his taxable income.
In a best case, that's $300,000 a year, tax-free, with no management responsibilities. For an investor focused on legacy and long-term wealth, that's a powerful position.
What About Taking $5 Million and Avoiding an Exchange?
Exchange Planning Corporation also ran a report showing what happens if Leo takes $5 million out of the exchange and only reinvests $2 million into DSTs.
The results were striking. Not only would his DST income drop by $900,000 over five years (because he's investing less), but he'd also owe approximately $810,000 in taxes on the cash boot itself. And the income earned on that $5 million in a taxable investment. Another $870,000 in taxes over the same period!
That's a total of roughly $1.65 million in additional taxes—just for choosing to take the money out.
This is the math that changes minds. It's not that taxable investments can't earn higher returns. It's that the tax cost of getting the money out, combined with the ongoing tax on the income it earns, creates a gap that's very hard to close.
The Smaller Boot Option
On the other hand, the same report showed that if Leo took $1.3 million in boot, the total tax would be about $220,000. The tax rate is lower because Leo is taking less money—and he's paying the tax at a lower marginal rate.
Leo saves taxes in two ways: he took less money, and the money he did take is taxed more favorably. That's a very different outcome than the $5 million boot scenario.
So What Should Leo Do?
We bet you're getting curious. Leo's choice might seem obvious at this point—but we can't tell you what Leo decided, because Leo is hypothetical.
What we can tell you is that almost every person Exchange Planning Corporation talks to about a 1031 exchange ends up investing at least most—if not all—of the money into a new qualifying 1031 property or DST.
These are estimates made for comparison. We use the same variables across scenarios to give investors an apples-to-apples view. Exchange Planning Corporation is not trying to predict what will happen over the next 14 or 15 years—they are showing you what the math says today so your clients can make an informed decision. There can be no guarantee that any investment will achieve its stated objectives.
Frequently Asked Questions
What is boot in a 1031 exchange?
Boot is any cash or value received during a 1031 exchange that isn't reinvested into replacement property. Boot is taxable—and the tax rate depends on how much you take and your overall income. Taking less boot often means a lower rate on the boot you do take.
Can I do a partial 1031 exchange and still save on taxes?
Yes. A partial exchange defers taxes on the portion you reinvest. But the boot you take is subject to capital gains tax, depreciation recapture, and potentially the 3.8% Medicare tax. Exchange Planning Corporation's calculators can model different boot amounts so you can see the exact trade-off.
Why does tax-deferred real estate outperform higher-return taxable investments?
Two reasons. First, you avoid a large upfront tax bill—so more capital stays invested from day one. Second, ongoing income from DSTs can be sheltered by depreciation for years. A taxable investment earning 9% has to overcome both the upfront tax and the annual tax drag—which is why the math often favors exchanging.
Next Steps
Contact the specialists at FGG1031 |First Guardian Group to assist in analyzing your options when considering 1031 exchange versus cash out options. A 1031 exchange may not be the best option for every investor, and we can help evaluate the pros and cons to allow better informed decisions. You can also download our latest ebooks for more information:
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