BiggerPockets

I have a problem and would love to hear some opinions on this.
Here is the scenario: a $1.5M tax exposure (net profits on sale of property) and a lack of desire to pay Uncle S. and CA 50% of that ($750k).

So the question is, would you pay the tax and keep gong or would you 1031 exchange this into a buy and hold deal (perhaps commercial deal or 100+ unit apartment building) to avoid the tax?

If you pay the tax, keep in mind you would have until next year to pay it so perhaps take the $1.5M and reinvest into more deals that would net profits to pay s the tax so at the end of the day, perhaps you would still be left with $1.5M or 1031 and with the buy and hold, obtain cash flow passively to semi passively for years to come and not pay any tax.

Your thoughts are appreciated.
- Will Barnard

Wish I could give you some wise advise, but I am unable to and would love to figure out how to have this issue in the near future. :)

Best of luck!

The elementary school principal in me says "pay the taxes" because that will pay for TEN teacher's salaries for a year, but my investor mindset can't imagine paying that much if you don't have to.
IMHO, it all comes down to what kind of property you've got and what kind of property you want. If you stay in the same lane, you can avoid the taxes, but if you've just gotta change lanes to get around the slow driver, you may reach your destination more quickly. Look at all of the potential like kind properties, and stay in the slow lane (avoiding taxes) if the numbers look right. If the like kind properties that you've identified don't pan out to be racey enough after doing your due diligence, then turn on your blinker, get into the fast lane and buy what you really want. And if you do have to pay the taxes, feel good knowing that a large percentage of your CA taxes pays for teachers.

Great question. Years ago I had a client with a similar issue (much smaller numbers). I can't remember why but in the end his CPA explained he couldn't do a 1031. If I had a choice, I would do the 1031 and defer the gain.

@Will Barnard,

1031 into another property is my vote. Defer the heck out of those gains. lather, rinse, repeat. Is the property in CA? If not MOVE and then sell.

My vote is 1031 into other properties. Plural. The stepped up basis is also a great idea.

Another though is possibly consider a Family Limited Partnership(FLiP). You can gift at a discount AND you can spread that gain between family members to lower the taxable amount.

@Arjun K.,

If the property was in CA, he would be subject to CA tax on the gain.

I don't know much about 1031 so I could be way off. However, is it possible to take the 1.5 mil, buy a property all cash using a 1031, wait the year to meet seasoning requirements, and then cash out refi the property? You wouldn't be able to take 100% out obviously, but 75% out with 25% equity is better than 50% to Uncle Sam.

@Will Barnard let me be the first to say Congratulations! It's a good Problem to have.

It sounds like you are past the point of moving in for a couple of years? (250-500K exclusion depending on marital status)

I'm sure you have already considered if you need the income on your returns?

Reading your comments above it sounds like you want to add to your lending business and not wait for a refi on the 1031?

i like @joel owens stepped up cost basis advice

However, because you want to add to the lending side of your business, maybe the best strategy would be a blend of both.

You do not have to spend all of your 1031 funds. However any amount not spent will be considered cash boot and will be subject to capital gains taxes and any applicable recaptured depreciation. For example: The Relinquished (sold) property is sold for profit of $1,500,000.00. The Acquired (bought) property is bought for $750,000.00. The $750,000.00 would be considered cash boot and would be taxable. (this is for the benefit of the audience, you know all this;)

I see this as both an opportunity cost and lifestyle decision, Will.

If you pay the taxes, you'll have $750k left over and the freedom to use it for anything you want. I know you flip homes and occasionally lend money. If you like doing this, and see a future of being able to grow the money quickly, then pay the tax.

One problem with a 1031 exchange is that it locks you into investments you might not really want. You certainly wouldn't have the freedom to flip or loan the money. In effect, you have the choice between $750k tax free (the half left over after paying the taxes) that you can use for anything you want or locking the entire $1.5M into investment(s) you made solely to avoid taxes.

On the other hand, if a buy and hold commercial deal or 100+ unit apartment building is something you wanted to do anyway, and not just to avoid the tax, then the 1031 exchange would make sense. I'm generally not a fan of putting taxes at the front of all other investment decisions and I think that's what you're wrestling with.

Not a clear answer since the decision is not completely financial. Just helping to help clarify.

Also, for what it's worth, you're not locked into hard RE assets. Being a passive cash-flow investor, I would throw oil and gas into the mix. These are generally considered like-kind investments too.

Jeff

Will, I did a 1031 with a $700,000 property in 2010 and did another 1031 in 2012 with a $360,000 property. I also did a 1031 back in 2007.

While others on here talk about "deferring" taxes, you can actually avoid taxes if you let the properties you buy in a 1031 go to your descendents as the property gets a whole new basis. But verify this with your accountant.

What kind of property you buy is up to you, but if you pay all cash, then you can borrow against it to make loans. If you can borrow at 4.5% and loan it at 10-12%, you have a nice income. Plus the interest you pay on the money you borrowed is deductible on your Schedule C.

Remember what Rich Weese said, have half your long term rentals financed to the "hilt" and the other half "free and clear." Unfortunately for me, I am at about 75% to 25%, with the 75% being Free and Clear. Then again, I have kids older than you Will, so retirement is looking good.

On a side note, if you do a 1031, use a reputable company, I use First American Title, Exchange Department. A few years ago, a small Escrow Company here in Orange County that also did 1031 exchanges, was owned by a person who found out they were dying of cancer, so one day, ALL the money in the escrow exchange account disappeared, along with the owner.

So my advice is to do the 1031, the government did NOT take any risk and does not deserve that large of a chunk of your profit. But taxing Capital Gains is a subject that belongs in another thread.

By the way, when I lived in Colorado, I still had to pay California Income Tax on my California rentals. I paid the Colorado income tax first, but with Colorado being around 4%, I had to pay the difference between the CO rate and the CA rate, to California.

Steve, unfortunately "flips" are not defined. Would the IRS say a property bought as an investment, imprroved, and held for 13 months or more qualify? Would they question intent? Say the intent was to do exactly as described? What if the holding period was 6 months or 25 months? Does the code or case law spell this out?