How to determine 1031 Construction Value?

[Jonathan Felts]

If I sell my property for $600k and owe $300k on a loan, I walk away with $300k minus agent commission ($30K). If I want to roll that into a fixer 1031 construction loan project, I understand that the property purchase price can be less than the down leg as long as I use the entire $300k profit for the down payment and cap-x improvements. Is that correct? Does the after cap-x value have to be more than my sold property? How is that ARV determined?

[Bill Exeter]

The reinvestment must meet two requirements to qualify for 100% tax-deferred exchange treatment.  You must trade equal or up in value based on your Net Sale Price (Gross Sale Price less certain routine selling expenses), so about $570K in your example, and you must reinvest all of your cash equity that comes out of the sale of your relinquished property.  

You can structure an Improvement 1031 Exchange where the Qualified Intermediary acquires and holds or "parks" legal title to the replacement property while you make the intent improvements to the replacement property within the 180 calendar day exchange period. The costs to acquire the property and the costs of the improvements will determine the amount that you have reinvested. The ARV has nothing to do with the 1031 Exchange reinvestment computation.

You can certainly "trade down" in value, but the amount that you do not reinvest will be taxable.  For example, if you sell for $600K, subtract $30K in routine selling expenses, and only reinvest $300K, you have traded down by $270K ($600K less $30K less $300K) and the $270K would be taxable (unless offset by something else). 

[Jonathan Felts]

Thanks Bill, so in my case I have a $300k loan on the property, does that factor in "selling expenses"?  If I have $270k of realized profit ($600k - $30k - $300k = $270k), do I go into a $600k+ property or can I go into a $300k property?

[Bill Brandt]

The Loan has nothing to do with profit which has nothing to do with the amount you have to buy. 

Your “profit” is selling price minus selling costs minus improvements minus purchase price. For all we know you’re losing money on this deal if you paid more than $570k plus improvements for it. Don’t forget you’ll also have 25% depreciation recapture tax if you don’t do the 1031  

What you must buy is selling price minus selling costs, in this case $570k. But you’d want a reason to pay $30k in closing costs and probably a higher interest rate loan to buy an equal value property. This new one has to be that much better. 

[Bill Exeter]

Bill is right on the money.  The loan has nothing to do with profit or taxable gain or what you must reinvest.  It is just part of the "capital deck" in terms of how you financed the property.  

[Dave Foster]

@Jonathan Felts. The actual cost of the as is land + actual costs of improvements is the number that you'll use to determine where you end up with your reinvestment target.

Your reinvestment target can be estimated very closely by simply adding the cash that goes into your exchange plus the amount of any mortgage paid off.  If $370K goes into your exchange account and the mortgage pay off was $300K then your reinvestment target to avoid all tax would be $670K using all $370K of proceeds.  You can buy less and you can take cash.  But you pay tax on the difference as if you took profit (what we would want to call a return of capital the IRS says is profit first when doing a 1031).

If you're thinking that you'll end up purchasing less in total by the time you get the improvements all done then a reverse or improvement exchange mentioned above could work but might not be the most cost effective action to avoid the expensive cost of a reverse type exchange (and the associated added cost to financing) you might think. It's unclear whether you are talking a new construction project or a building that needs significant cap ex improvements.  Getting new construction done in the 180 day safe harbor from the IRS is almost impossible these days.  If you're doing significant improvements then that is more achievable.

The alternative that might work as well or better would be to purchase two replacement properties.  Purchase the property you will improve with the maximum loan possible then purchase a second property for cash.  This way you can complete a simple straight exchange and save the costs of an improvement exchange.  Once the 1031 is complete immediately do a cash out refi of the property you bought for cash.  The refi is not a taxable event and you are not under 1031 time constraints or the expense of a reverse exchange to complete your improvements.

[Jonathan Felts]

Dave, this was very informative and a lot of value. Thank you for also giving a strategy I hadn’t know existed to get this done easier!

[Jonathan Felts]

Thanks Bill, this helped a lot, was hoping the cost of the loan has some offset, but thanks for clearing up!

[Jonathan Felts]

@Bill Exeter Here the details of my deal. I bought with partners the commercial property in 2018 for $474,000. I owned 50%. I bought out my partners earlier this year, so own the LLC that owns the property 100%. I bought them out for $291,000, which was half of market rate at that time. However the rents aren't great and its near a 2% cap. The sales price is right around $690,000 (have an offer). We have depreciated the property since we bought, $8000/year based on building only ($315,000) leaves me with $474,000 - $40,000 = $434,000 base value. I would have a 4.5% commission from the agent who is repping both sides, so $31,104.

Is my value then $690,000 - $31,104 = $658,896. Is this the value of the property I must buy?  Does buying my partners out at market rate take away from my basis at all?

[Dave Foster]

@Jonathan Felts your reinvestment requirements will be to purchase around 658K in replacement investment real estate (contract price minus closing costs/commissions) using all of the net cash (net sale of 658K minus mortgage payoff).

your basis determines your profit. And yes buying your partners out would increase your basis.   But in a 1031 your basis doesn't matter (other than deciding if you need to do a 1031).  Regardless of your basis you must purchase at least as much as you sell and use all of the cash to do so if you want to defer all tax.  You can purchase less than you sell.  And you can take cash out.  When you do the IRS simply says that you are taking profit first.  So the difference is taxable.

[Jonathan Felts]

@Dave Foster can you pay off other notes for existing investment properties if you use all the money or does it have to be new properties?

[Dave Foster]

@Jonathan Felts, The only debt that can be paid of is debt attached to the relinquished property at the time of it's sale.  Your replacement for the 1031 has to be actual real estate.  You cannot pay off debt on other properties.