What to do with a 1031 Exchange

Question

So I have not started yet, but after having an initial consult with my investor agent buddy, we think that I could potentially walk away from a sale with between $60-70K profit. With that amount of profit and only owning for 2yrs, I would want to at least look into doing a 1031. My dilemma is what is the best use of the cash, so here are thoughts I have had. BTW currently trying to focus on STR's and have one property in the Smoky Mountains, and am remodeling two properties local to me to rent as an STR.

- Use $70k as a 10% down loan on another vacation rental in a separate market from the Smoky Mountains. ($700k PP).

- Use $70k as a 20-25% dp on a vacation rental in another market. ($300k PP).

- Use $70K as 20-25% dp two SFH in my local market or one SMF. (Two $175k or One $350k).

- If possible, use $70k to buy land outright and build?

Dave Foster · Answer

@Chris Allen, actually both a vacation rental with a 2nd home loan and a purchase of land for a future vacation rental are fine for a 1031.  BUT @Joe Splitrock, is right, the purchase of land and construction would have to be structured as a reverse construction exchange.  You can't exchange into improvements on land you own.  And reverses are complex and pricey.  And they basically won't work in this market because the QI for the 1031 can only hold the lot for 180 days.  No construction is getting done that quickly.  But you could purchase just the land as one of your 1031 replacements.

A vacation rental with 2nd home financing is fine from the 1031 perspective.  Lender requirements are usually that the new property be at least XX miles from where you live.  And you agree to use it at least 2 weeks a year for personal use.  The IRS does not care what the source of your loan is.  And Neither of these disqualifies a property from being a 1031 replacement.  We see quite a few each year.  But make sure your lender understands the down payment is coming from a 1031 exchange account.  Some internal underwriting guidelines will not let them do it.  Not that it's illegal.  Just their internal guidelines.

Joe Splitrock · Answer

I think a couple of your options are off the table. When you are talking 10% down on a vacation rental, that implies using a second home loan. That is not an investment loan - it is a vacation home. Yes, you can rent a vacation home, but it is personal mixed use, not direct investment. The $70K to buy land would probably not be considered like kind either. A vacant lot generally isn't considered like kind to a rental property and building isn't allowed with 1031 funds. Of course when you read up on like kind exchanges, people stretch the interpretation to meet their own needs. You could literally do whatever you want and until you get audited, it is not an issue. I am more in the camp of keeping it clean, so you don't put yourself in a bad position.

Bill B. · Answer

Don’t forget. You don’t have to invest all your “profit” you have to invest all the proceeds.

You forgot to include any numbers in your case so I’ll make up an example.

You bought for $300k with a loan for $225k and you sell for $410k. It costs $40k to sell so you net $370k. Now you must buy a property or properties that cost at least $370k and you must use the $145k cash that you net from the sale.

You’ve already lost $40k in selling costs. You’re only looking to save $11k in taxes. Flushing $40k vs $50k to realize $70k isn’t that much different. And you better have a good reason. How much better this replacement property is going to be or how bad the current property is. Otherwise you’re just paying an effective 35% - 45% tax on your gain.

Chris Allen · Answer

I have not thought about this yet, so you could very well be right. My thought was start it out as a 1031, and if I am unable to find something I actually like, then just eat the tax bill and take the cash.

Chris Allen · Answer

I just got a HELOC on my primary residence which is a duplex for that reason. This particular property I dont really want to keep long term.

Thomas Veazey · Answer

Hi Chris. I'm going through a 1031 myself right now.

A lot of your questions are specific to your investment philosophy. You have to figure out what your goals are and go from there. My two cents (without any more information) would be: don't dive into new builds as that's a whole new learning curve and you have experience in other areas that you can build on AND scaling up into small multifamily (and then bigger multifamily) is smart because it increases income without proportionately increasing costs.

On the 1031, I'm not sure your gain is a huge tax bill.

Have you done the math on your taxes owed? Did you account for depreciation and interest deductions on your other properties? Sometimes those gains are swallowed by your other "losses" and the tax bill isn't as high as it seems.

IMO 1031s are a necessary tool to sheild large gains. 70k isn't small (!) but after accounting for lots of other factors, you may be best off paying the tax and having cash in your pocket for the right deal without a time constraint.At the end of the day, congrats on your gain! That's a win.

What to do with a 1031 Exchange

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