Proceeds vs Profit on a 1031 Sale

Jimmy Lin · 2022-10-08T12:26:13-07:00

Reading some 1031 articles on BP and it is a little confusing that the term proceeds and profits are being used interchangeably. From: https://www.biggerpockets.com/..."Also, all the proceeds from the sale need to be reinvested. So, if I made $100K, all of that needs to be moved over. Or say I made $200K, the new property could be $201K or even $1 million. The point is the new property has to get purchased for more than the price of the old, and I have to roll all the profits over to a new property held in the same entity."From my understanding, proceeds and profits are two different things. Lets use this example: Purchase price of investment property is 100k, with 80k in outstanding mortgage. Property is sold at 150k to be 1031X'd. In this example, the sales proceeds is 70k (150k - 80k), while the profit is 50k (150k - 100k). Which amount will need to be reinvested in the new deal?

Dave FosterBusiness Member

Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes

3y

@Jimmy Lin, You are 100% correct when you say that proceeds and profits are different things. Proceeds are whatever cash is left after closing a sale. This could be much more than your profit if you've paid your loan down. Or it could be much less if you've refinanced at any point.

Profit is a specific calculation which is the adjusted cost basis (acquisition price+capital improvements-depreciation) subtracted from the net sales price (contract price minus closing costs not including loan payoff).

In your example the proceeds would be $70K. And your profit would be $50k. So far you're right on. You'll never pay tax on any more than $50K. BUT.......

When you do a 1031 exchange the IRS says that any amount of money you take ot of the exchange is taking profit first. And any amount you purchase less than you sold is taking profit. They will not let you take anything from a 1031 exchange that benefits you (either by increasing assets - cash, or decreasing liabilities - less debt) unless they also get their tax.

This is why you want to think of the 1031 reinvestment requirements as a 2 part rule - You must purchase at least as much as your net sale ($150K) and you must use all of your cash proceeds in your replacement purchase ($70K).

You want to say that the $20K you take from the sale is your original capital. And you're reinvesting all of the profit. The IRS says, "Nope. You are taking $20K profit first and only reinvesting your original capital of $20K and the remaining $30K of profit."

It doesn't seem fair. But it's their cost for the privilege of letting you defer paying tax with a 1031.

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Jimmy Lin

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Investor · Houston, TX · Member since 2017 · 49 posts · 36 votes

3y

@Dave Foster

Thank you Dave. This may seem silly to you, but my overall capital gain will be around $61,000 after fees and commission. That translates to $9,100 of tax liability.

Does it make sense to buy at the current market to save $9k in taxes? It seems like the market is softening and prices are coming down . Would this capital be better invested maybe next year?

Thank you

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Dave FosterBusiness Member

Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes

3y

@Jimmy Lin, $9K is real money to anyone!! in 08 I had a bunch of clients who were so far under water on their real estate they needed garden hoses to breath. Guess what - None of them who didn't have to sell lost a penny. They simply held their properties (making money the entire time) and in the last couple of years have been able to sell at a nice profit and 1031 again. Dips come and go. I' became an advocate of buying right so you can hold on. And not worrying about what you paid for a property.

9K out of your pocket today versus keeping that and having to wait through a couple of years of positive cash flow to free it up isn't a tough decision for me. But everyone has a different comfort level. For many, taxes are just a cost of business. Those folks don't do 1031s. But if that's the case then they probably don't do 401ks either. Because that is the same principle.

Personally I feel like anyone selling right now is in a great position. Because you can take todays gain and invest in property that is softening. This is a shoulder season. People are selling still relatively high. and able to buy slightly lower - That's perfect 1031 land.

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Jimmy Lin

OP

Investor · Houston, TX · Member since 2017 · 49 posts · 36 votes

3y

@Dave Foster Thanks again for your insights!

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Proceeds vs Profit on a 1031 Sale

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