Dan is a new client that I started working with just a few months ago.
He is an old timer in the real estate business and in fact Dan has owned most of his real estate for over 20 years. Almost all of his properties were single family rentals and many of which he bought for a super deal at around $40K to $70K each.
Considering the rise in market value since his original purchase it is safe to say that now each property is worth between $250K and $375K. Dan was nearing retirement age and when I met with him he told me that his goal over the next year or two was to sell his single family rentals and hopefully move his money into larger commercial deals.
His friends had invested in triple net shopping centers and the promise of fewer management headaches was something very attractive to Dan, especially since he and his wife were making plans to travel the world together.
Based on the appreciation, Dan was estimating a total of $1M in liquidity once he sold all of his rental properties. With the shopping centers he was hoping to invest in, he felt he would have some money left over which he intended to use to make some overdue improvements on his primary home.
What Dan forgot to account for in his plans was Uncle Sam’s portion of the gain. With the estimated sales price of his rentals, he was looking at long term capital gains of close to $750,000 with an estimated tax of over $100,000.
Prior to meeting with me, his old CPA had suggested a 1031 exchange as a strategy to reduce his potentially large tax bill. Since Dan’s plan was to re-invest the money back into investment property, a 1031 exchange made sense.
What he did not like was the fact that his old CPA also told him that he would not be able to take any money out to improve his primary home. In fact, any cash that Dan took out of the exchange would be subject to taxes even if he used the 1031 exchange strategy.
What is a 1031 Exchange?
A 1031 Exchange simply put is a tax deferred exchange.
This strategy allows you to sell one property and then using the proceeds to acquire another property during a specific time period. There is only one difference between doing this and doing a regular sale of a property and it’s that you must pay taxes on any gains you recognize while doing the exchange. Generally you can defer taxes on any gains. So simply put when doing a 1031 exchange, your sales are not taxable.
So why don’t all investors use 1031 exchanges to avoid taxes? Well, just like most other loopholes, there are rules you must meet in order to benefit from this tax break. Let’s take a look at the basic concepts for a 1031 exchange. In order for a 1031 exchange to be done correctly to minimize or avoid current taxes, these two rules below must be met:
- The total purchase price of the replacement “like kind” property must be equal to, or greater than the total net sales price of the relinquished, real estate, property.
- All the equity received from the sale, of the relinquished real estate property, must be used to acquire the replacement, “like kind” property.
In Dan’s case, the IRS doesn’t care that the property being sold is a single family and that the replacement property will be a shopping center. As long as they are both “rental real estate” he should meet the IRS definition of “like-kind” since he is selling one rental and replacing it with another rental.
For Dan, what he could do is sell a few of his single families and then use the total money from the sale toward the purchase of a shopping center, an easy way to delay the need to pay over a hundred thousand in taxes! What this means is that Dan can re-invest all his money back into real estate today without having to pay the government.
Taking Cash Out During a 1031 Exchange Tax Free
Now what about the fact that Dan was told he would not be able to take money out of the 1031 exchange to pay for the improvements of his primary home?
Well first off, Dan’s old CPA was correct in that you cannot exchange an investment property for a primary home as these are not considered “like kind” in the eyes of the IRS. However, while working with Dan we discovered anther potential loophole to help him save on taxes.
Remember, earlier we said that in a 1031 exchange the replacement property’s purchase price and equity must be equal or greater than the property being sold. Well, what is not limited is the ability to refinance to take out money.
For example, if Dan finished out his 1031 exchange and met all the regular requirements, he should be able to refinance on the investment property and take out money to use for improvements on his primary home. Since the refinance is done outside of the 1031 exchange and after the exchange has been completed, Dan will generally not have any taxes due at the time he refinances on the shopping center.
In fact, what a lot of investors do not know is that the money pulled out via a refinancing after a 1031 exchange can be used for pretty much anything. That’s right…it does not have to be used for real estate. For example, if Dan wanted to use his money to buy a boat or go on his world trip instead of improving his primary home, he is able to do so without any current taxes due on the money he pulled out.
Of course, these types of transactions are highly complex and needs careful guidance prior to implementation. So if you are ever considering selling a property, be sure to meet with your tax advisor before you pull the trigger as there are many strategies that you may be able to use that can help you to defer or even permanently erase your tax bill.